Inflation/Deflation

Executive Summary Turbulence remains the signal feature of 2022 as worries about inflation and the Fed’s reaction to it continue to haunt investors and plague financial markets. Despite four-decade highs in measured inflation, long-run inflation expectations have held fast, keeping an inflation vicious circle from taking hold. As the diminishing threat from COVID helps unsnarl supply and transportation bottlenecks, it will also reduce the potential for expectations to become unmoored. The labor market has been sending encouraging signals for the economy and corporate profit margins. Although payrolls continue to expand at a robust pace and job openings remain near record highs, upward wage pressures appear to be losing momentum. Households have proven willing to spend their excess pandemic savings and maintain a sizable cushion to keep the economy growing near its long-run trend pace.  All Is Not Yet Lost All Is Not Yet Lost All Is Not Yet Lost Bottom Line: Markets remain volatile, subject to sharp swings upon any data points that portend a shift in the Fed’s tightening campaign. The August CPI report did not change our view that the consensus is underestimating the potential for positive earnings surprises in the next two quarters and we continue to recommend overweighting equities over the next three to six months. Feature Will the real inflation trend please stand up? Financial markets were emboldened by July’s CPI release, which reported a 0.1% month-over-month decline in inflation, 10 basis points below expectations, and demoralized by August’s edition, which reported a 0.1% month-over-month increase, 20 basis points above expectations. Core inflation, which backs out changes in volatile food and energy prices, came in at 0.6% in August after a 0.3% reading in July. In the harsh light of the August release, the July data point looked anomalous to the naked eye after holding between 0.6 and 0.7% in the three previous months. Related Report  US Investment StrategyChartbook Equities swooned after the release, but policymakers and economic participants should focus on data trends rather than data points. Though we share in the general disappointment that inflation remains elevated, we continue to expect that headline CPI growth will abate to around 4% over the coming months. The supply of goods and services will increase as COVID’s threat continues to recede, while demand will slacken as the Fed and other major central banks continue to tighten monetary policy. The end of COVID restrictions will help to facilitate the ongoing shift in demand from goods to services. All in all, the underlying trend toward decelerating inflation will not be upended by noisy one-off data points. Stubbornly high inflation prints increase the risk that inflation expectations will become unmoored, feeding a self-reinforcing cycle in which high prices beget even higher prices, but there is no sign yet that they are poised to break out. Persistent inflation also increases the risk that the Fed will overdo the tightening and induce a deeper recession than would otherwise occur. We remain vigilant on both fronts, but believe markets are overestimating the probability of each risk. The charts that follow – tracking COVID’s course, inflation expectations, the labor market, household balance sheets and the outlook for S&P 500 earnings – show the data underpinning our stance. We will abandon our sanguine tactical view if consumers show signs of retrenching, which would torpedo our better-than-consensus growth outlook, or if inflation expectations show signs of becoming unmoored, which would force the Fed to move to throttle the economy immediately. Neither condition has yet been met, however, and we continue to believe that the consensus is underestimating the potential for upside earnings surprises. Chart 1Omicron Has Come And Gone ... Omicron Has Come And Gone ... Omicron Has Come And Gone ... Chart 2... With Much Less Of An Impact Than Delta ... With Much Less Of An Impact Than Delta ... With Much Less Of An Impact Than Delta Chart 3The Picture Looks Even Better Outside The US ... The Picture Looks Even Better Outside The US ... The Picture Looks Even Better Outside The US ... Chart 4... Though Ancillary Counts May Not Be So Rigorously Maintained ... Though Ancillary Counts May Not Be So Rigorously Maintained ... Though Ancillary Counts May Not Be So Rigorously Maintained Chart 5Watch This Space Watch This Space Watch This Space Chart 6Consumers Are Still Not Chasing Big-Ticket Items Consumers Are Still Not Chasing Big-Ticket Items Consumers Are Still Not Chasing Big-Ticket Items Chart 7Near-Term Expectations Are Way Down ... Near-Term Expectations Are Way Down ... Near-Term Expectations Are Way Down ... Chart 8... And Long-Term Expectations Remain Contained ... And Long-Term Expectations Remain Contained ... And Long-Term Expectations Remain Contained Chart 9Steady As She Goes Steady As She Goes Steady As She Goes Chart 10We're All Doomed! We're All Doomed! We're All Doomed! Chart 11Oh, Wait, Never Mind Oh, Wait, Never Mind Oh, Wait, Never Mind Chart 12Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Initial Claims Are Nearly 20% Below Their Mid-July Peak ... Chart 13... And Openings Have Come Only Slightly Off Of Theirs ... And Openings Have Come Only Slightly Off Of Theirs ... And Openings Have Come Only Slightly Off Of Theirs Chart 14Ready, Willing And Able To Keep The Economy Going Ready, Willing And Able To Keep The Economy Going Ready, Willing And Able To Keep The Economy Going Chart 15Down, But Not Out Down, But Not Out Down, But Not Out Chart 16Margins Remain Elevated ... Margins Remain Elevated ... Margins Remain Elevated ... Chart 17... And Profit Warnings Are Few And Far Between ... And Profit Warnings Are Few And Far Between ... And Profit Warnings Are Few And Far Between Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran.   Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference.  China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2  Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort.  Chart 2China’s Commodity Import Vulnerability Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 3China's Imports Of Semiconductors China's Imports Of Semiconductors China's Imports Of Semiconductors     3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure China's US Dollar Exposure China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets.   Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis.  Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5).   Chart 5Europe Handling Natural Gas Crisis Well … So Far Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 7Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire.   However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome.  Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2     US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3    Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com.                                                                                         Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report     Executive Summary GIS Projection For The EUR/USD It’s Time To Buy The Euro It’s Time To Buy The Euro We went long the euro early last week, as EUR/USD hit our buy limit price of $0.99. Despite a near cut-off of Russian gas imports, European gas inventories have reached 84% of capacity – above the 80% target that the EU set for November 1st. The latest meteorological forecasts suggest that Europe will experience a warmer-than-normal winter. This will cut heating usage, likely making gas rationing unnecessary. Currencies fare best in loose fiscal/tight monetary environments. This is what Europe faces over the coming months, as governments boost income support for households and businesses, while ramping up spending on energy infrastructure and defense. For its part, the ECB has started hiking rates. Since mid-August, interest rate differentials have moved in favor of the euro at both the short and long end. Rising inflation expectations make it less likely that the ECB will be able to back off from its tightening campaign as it did in past cycles. A hawkish Fed is the biggest risk to our bullish EUR/USD view. We expect US inflation to trend lower over the coming months, before reaccelerating in the second half of 2023. However, as the August CPI report highlights, the danger is that any dip in inflation proves to be shallower and shorter-lived than previously anticipated. Bottom Line: Although significant uncertainty remains, the risk-reward trade-off favors being long EUR/USD. Our end-2022 target is $1.06.   Dear Client, I will be meeting clients in Asia next week while also working on our Fourth Quarter Strategy Outlook, which will be published at the end of the month. In lieu of our regular report next Friday, you will receive a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards, Peter Berezin, Chief Global Strategist It’s Just a Clown Chart 1Investors Are Bullish The Dollar, Not The Euro Investors Are Bullish The Dollar, Not The Euro Investors Are Bullish The Dollar, Not The Euro The scariest part of a horror movie is usually the one before the monster is revealed. No matter how good the special effects, the human brain can always conjure up something more frightening than anything Hollywood can dream up. Investors have been conjuring up all sorts of cataclysmic scenarios for the upcoming European winter. In financial markets, the impact has been most visible in the value of the euro, which has tumbled to parity against the US dollar. Only 23% of investors are bullish the euro at present, down from a peak of 78% in January 2021 (Chart 1). Conversely, 75% of investors are bullish the US dollar. More than half of fund managers cited “long US dollar” as the most crowded trade in the latest BofA Global Fund Manager Survey (“long commodities” was a distant second at 10%). As we discuss below, the outlook for the euro may be a lot better than most investors realize. While my colleagues, Chester Ntonifor, BCA’s chief FX strategist, and Mathieu Savary, BCA’s chief European strategist, are not quite ready to buy the euro just yet, we all agree that EUR/USD will rise over the long haul. Cutting Putin Loose Natural gas accounts for about a quarter of Europe’s energy supply. Prior to the Ukraine war, about 40% of that gas came from Russia (Chart 2). With the closure of the NordStream 1 pipeline, that number has fallen to 9% (some Russian gas continues to enter Europe via Ukraine and the TurkStream supply route). Yet, despite the deep drop in Russian natural gas imports, European natural gas inventories are up to 84% of capacity – roughly in line with past years and above the EU’s November 1st target of 80% (Chart 3). Chart 2Despite A Sharp Drop In Imports Of Russian Natural Gas… It’s Time To Buy The Euro It’s Time To Buy The Euro Chart 3...Europeans Managed To Stock Up On Natural Gas For The Winter Season ...Europeans Managed To Stock Up On Natural Gas For The Winter Season ...Europeans Managed To Stock Up On Natural Gas For The Winter Season   Europe has been able to achieve this feat by aggressively buying natural gas on the open market. While this has caused gas prices to soar, it sets the stage for a retreat in prices in the months ahead. European spot natural gas prices have already fallen from over €300/Mwh in late August to €214/Mwh, and the futures market is discounting a further decline in prices over the next two years (Chart 4). Chart 4The Futures Market Is Discounting A Further Decline In Natural Gas Prices It’s Time To Buy The Euro It’s Time To Buy The Euro Chart 5Futures Prices Of Energy Commodities Provide Some Limited Information On Where Spot Prices Are Heading It’s Time To Buy The Euro It’s Time To Buy The Euro Follow the Futures? Futures prices are not a foolproof guide to where spot prices are heading. As Chart 5 illustrates, the correlation between the slope of the futures curve and subsequent changes in spot prices in energy markets is quite low. Nevertheless, future spot returns do tend to be negative when the curve is backwardated, as it is now, especially when assessed over horizons of around 12-to-18 months (Table 1).   Table 1Energy Commodity Spot Price Returns Tend To Be Negative When The Futures Curve Is Backwardated It’s Time To Buy The Euro It’s Time To Buy The Euro Our guess is that European natural gas prices will indeed fall further from current levels. The latest meteorological forecasts suggest that Europe will experience a milder-than-normal winter (Chart 6). This is critical considering that natural gas accounts for over 40% of EU residential heating use once electricity and heat generated in gas-fired plants are included (Chart 7). Chart 6Meteorological Models Suggest Above-Normal Temperatures In Europe This Winter It’s Time To Buy The Euro It’s Time To Buy The Euro   Chart 7Natural Gas Is An Important Source Of Energy For Heating Homes In The EU It’s Time To Buy The Euro It’s Time To Buy The Euro A warm winter would bolster the euro area’s trade balance, which has fallen into deficit this year as the energy import bill has soared (Chart 8). An improving balance of payments would help the euro. Europe is moving quickly to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG (Chart 9). A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. Chart 8Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Chart 9Europe Is America's Largest LNG Customer It’s Time To Buy The Euro It’s Time To Buy The Euro In the meantime, Germany is building two “floating” LNG terminals. It has also postponed plans to mothball its nuclear power plants and has restarted its coal-fired power plants, a decision that even the German Green Party has supported. France is aiming to boost nuclear capacity, which had fallen below 50% earlier this summer. Électricité de France has pledged to nearly double daily production by December. For its part, the Dutch government has indicated it will raise output from the massive Groningen natural gas field if the energy crisis intensifies. Fiscal Policy to the Rescue On the policy front, European governments are taking steps to buttress household balance sheets during the energy crisis, with nearly €400 billion in support measures announced so far (and surely more to come). Although these support measures will be offset with roughly €140 billion of windfall profit taxes on the energy sector, the net effect will be to raise budget deficits across the region. However, following the old adage that one should “finance temporary shocks but adjust to permanent ones,” a temporary spike in fiscal support may be just what the doctor ordered. The last thing Europe needs is a situation where energy prices fall next year, but the region remains mired in recession as households seek to rebuild their savings. Such an outcome would depress tax revenues, likely leading to higher government debt-to-GDP ratios. Get Ready For a V-Shaped Recovery Stronger growth in the rest of the world should give the euro area a helping hand. That would be good news for the euro, given its cyclical characteristics (Chart 10). The European economy is especially leveraged to Chinese growth. It is likely that the authorities will loosen the zero-Covid policy once the Twentieth Party Congress concludes next month, and new anti-viral drugs and possibly an Omicron-specific booster shot become widely available later this year. That should help jumpstart China’s economy. More stimulus will also help. Chart 11 shows that EUR/USD is highly correlated with the Chinese credit/fiscal impulse. Chart 10The Euro Is A Cyclical Currency The Euro Is A Cyclical Currency The Euro Is A Cyclical Currency Chart 11EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse   All this suggests that the prevailing view on European growth is too pessimistic. Even if Europe does succumb to a technical recession in the months ahead, it is likely to experience a V-shaped recovery. That will provide a nice tailwind for the euro. Loose Fiscal/Tight Monetary Policies: The Winning Combo for Currencies Chart 12Fiscal Policy Has Eased Structurally In The Euro Area More Than In Other Advanced Economies It’s Time To Buy The Euro It’s Time To Buy The Euro A tight monetary and loose fiscal policy has historically been the most bullish combination for currencies. Recall that the US dollar soared in the early 1980s on the back of Paul Volcker’s restrictive monetary policy and Ronald Reagan’s expansionary fiscal policy, the latter consisting of huge tax cuts and increased military spending. While not nearly on the same scale, the euro area’s current configuration of loose fiscal/tight monetary policies bears some resemblance to the US in the early 1980s. Even before the war in Ukraine began, the IMF was forecasting a much bigger swing towards expansionary fiscal policy in the euro area than in the rest of the world (Chart 12). The war has only intensified this trend, triggering a flurry of spending on energy and defense – spending that is likely to persist for most of this decade.   The ECB’s Reaction Function After biding its time, the ECB has joined the growing list of central banks that are hiking rates. On September 8th, the ECB jacked up the deposit rate by 75 bps. Investors expect a further 185 bps in hikes through to September 2023. While US rate expectations have widened relative to euro area expectations since the August US CPI report (more on that later), the gap is still narrower than it was on August 15th. Back then, investors expected euro area 3-month rates to be 233 bps below comparable US rates in June 2023. Today, they expect the gap to be only 177 bps (Chart 13). Real long-term bond spreads, which conceptually at least should be the more important driver of currency movements, have also moved in the euro’s favor. In the past, ECB rate hikes were swiftly followed by cuts as the region was unable to tolerate even moderately higher rates. While this very well could happen again, the odds are lower than they once were, at least over the next 12 months. Chart 13Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Chart 14Euro Area: Inflation Expectations Have Risen Briskly Euro Area: Inflation Expectations Have Risen Briskly Euro Area: Inflation Expectations Have Risen Briskly For one thing, median inflation expectations three years ahead in the ECB’s monthly survey have risen briskly (Chart 14). The Bundesbank’s own survey paints an even more alarming picture, with median expected inflation over the next five years having risen to 5% from 3% in mid-2021 (Chart 15). Expected German inflation over the next ten years stands at a still-elevated 4%. Whether this reflects Germans’ heightened historical sensitivity to inflation risks is unclear, but it is something the ECB cannot ignore. Structurally looser fiscal policy has raised the neutral rate of interest in the euro area, giving the ECB more leeway to lift rates. A narrowing in competitiveness gaps across the currency bloc has also mitigated the need for the ECB to set rates based on the needs of the weakest economies in the region. Chart 16 shows that collectively, unit labor costs among the countries most afflicted by the sovereign debt crisis a decade ago have completely converged with Germany. Chart 15German Inflation Expectations Are Elevated German Inflation Expectations Are Elevated German Inflation Expectations Are Elevated Chart 16Europe's Periphery Has Closed The Competitiveness Gap With Germany Europe's Periphery Has Closed The Competitiveness Gap With Germany Europe's Periphery Has Closed The Competitiveness Gap With Germany While Italy is still a laggard in the competitiveness rankings, the ECB’s new Transmission Protection Instrument (TPI) – which allows the central bank to buy sovereign debt with less stringent conditionality than under the Outright Monetary Transactions (OMT) program – should keep a lid on sovereign spreads. This, in turn, will allow the ECB to raise rates more than it otherwise could. Hawkish Fed is the Biggest Risk to Our Bullish EUR/USD View Chart 17Supplier Delivery Times Have Fallen Sharply Supplier Delivery Times Have Fallen Sharply Supplier Delivery Times Have Fallen Sharply Tuesday’s hotter-than-expected August US CPI report pulled the rug from under the euro’s incipient rally, pushing EUR/USD back to parity. We have been flagging the risks of high inflation for several years (see, for example, our February 19, 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our thesis is that inflation will follow a “two steps up, one step down” pattern. We are probably near the top of those two steps now, with the next leg for inflation likely to be to the downside, driven by ebbing pandemic-related supply side-dislocations. Perhaps most notably, supplier delivery times have fallen sharply in recent months (Chart 17). These pandemic-related dislocations extend to the housing rental market. Rent inflation dropped after rent moratoriums were put in place, only to rebound forcefully once the moratoriums were lifted and the labor market tightened. Although official measures of rent inflation will remain elevated for some time, owing to lags in how they are constructed, timelier data on new rental units coming to market already point to a sharp decline in rent inflation (Chart 18). This is something that the Fed is sure to notice. Ironically, falling inflation could sow the seeds of its own demise. Nominal wage growth is currently very elevated, yet because of high inflation, real wages are still shrinking. As inflation comes down, real wage growth will turn positive. This will lift consumer sentiment, helping to buoy consumption (Chart 19). A pickup in consumer spending will cause the economy to overheat again, leading to a second wave of inflation in the back half of 2023. Chart 18Timelier Measures Of Rent Inflation Have Rolled Over Timelier Measures Of Rent Inflation Have Rolled Over Timelier Measures Of Rent Inflation Have Rolled Over Chart 19Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence Falling Inflation Will Boost Real Wages And Consumer Confidence As we discussed in our August 18th Special Report Dispatches From The Future: From Goldilocks To President DeSantis, the Fed will respond to this second inflationary wave by hiking the Fed funds rate to 5%. This will temporarily push up the value of the dollar, a process that will only stop once the US falls into recession in 2024 and the Fed is forced to cut rates again. Our projected rollercoaster ride for EUR/USD is depicted in Chart 20. We see the euro rising to $1.06 by year-end, peaking at $1.11 in the spring of 2023, falling back to $1.05 by late 2023, and then beginning a prolonged rally in 2024. Chart 20GIS Projection For The EUR/USD It’s Time To Buy The Euro It’s Time To Buy The Euro Chart 21The Dollar Is Very Overvalued Against The Euro Based On PPP The Dollar Is Very Overvalued Against The Euro Based On PPP The Dollar Is Very Overvalued Against The Euro Based On PPP Chart 21 shows that the dollar is 30% overvalued against the euro based on its Purchasing Power Parity (PPP) exchange rate. Thus, there is significant long-term upside to EUR/USD.   Implications for Other Currencies and Regional Equity Allocation Chart 22Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening The strengthening in the euro that we envision over the next six months or so will be part of a broad-based dollar decline. While BCA’s Foreign Exchange Strategy service sees more upside for the euro than the pound, GBP/USD will likely follow the same trajectory as EUR/USD. The yen is one of the cheapest currencies in the world and should finally gain some traction. If China abandons its zero-Covid policy and increases fiscal support for its economy, the RMB and other EM currencies should strengthen. Stock markets outside the US tend to fare best when the dollar is weakening. This includes Europe. As Chart 22 illustrates, there is a close correlation between EUR/USD and the relative performance of European versus US stocks. Thus, an above-benchmark exposure to international markets is appropriate during the coming months. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter Global Investment Strategy View Matrix It’s Time To Buy The Euro It’s Time To Buy The Euro Special Trade Recommendations Current MacroQuant Model Scores It’s Time To Buy The Euro It’s Time To Buy The Euro      

Executive Summary Global Manufacturing / Trade Will Contract Global Manufacturing / Trade Will Contract Global Manufacturing / Trade Will Contract The bar for the Fed to stop hiking rates is still very high. US inflation remains broad based. Core inflation is neither about oil and food prices nor is it about the prices of other individual items. The key variables that will determine inflation’s persistence are wages and unit labor costs. US wage growth is very elevated, and unit labor costs are soaring. Unless the US economy experiences a recession, core inflation will not drop below 3.5%. The Fed and the US stock market (and by extension global risk assets) remain on a collision course. The Fed will not make a dovish pivot until the stock market sell off, and equities cannot rally unless the Fed backs off. The imminent global trade contraction is bad news for EM stocks and currencies as well as global cyclicals. Bottom Line: A hawkish Fed amid a global trade/manufacturing recession is producing a bearish cocktail for global risk assets in general and EM risk assets in particular. Feature The majority of investors and strategists have been expecting an easing of US inflation to allow the Federal Reserve to completely halt or considerably slow the pace of its hiking cycle. For example, the Bank of America Global Fund Managers survey from September (taken before the release of the latest US CPI report) revealed that a net 79% of participants see lower inflation in the next 12 months. We at BCA’s Emerging Markets Strategy team have taken a different view. Even though we have been open to the idea that the annual rate of inflation (especially the headline measure) will drop in the months to come, we have been arguing that US core inflation will remain well above the 3.5-4% range for some time. What matters for the Fed’s policy is the level of core inflation, not just a decline in the inflation rate. With core inflation considerably above the Fed’s 2% target, we have maintained that the FOMC will uphold its hawkish bias. Consequently, global risk assets will continue selling off and the US dollar will overshoot. Analyzing the price dynamics of individual items − such as energy, food, shelter or cars – when assessing the outlook for inflation is akin to missing the forest for the trees. Chart 1US Core-Type Inflation Measures Are Very High US Core-Type Inflation Measures Are Very High US Core-Type Inflation Measures Are Very High When inflation is limited to several individual components of the consumption basket, neither central banks nor financial markets should react. This is true both when the prices of these individual components are rising (inflation) and when they are falling (deflation). However, central banks and, hence, financial markets, should respond to broad-based inflation. Therefore, investors need to look at the forest rather than focus on individual trees. In our February 18, 2022 report, we wrote the following: “US inflation has become broad based. Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation has risen substantially. Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor costs are calculated as nominal wages divided by productivity (the latter is output per hour per employee).” All of these points remain valid today. Chart 1 shows that core, median, trimmed-mean and sticky CPI are all rising at very fast annual rates, ranging from 6% to 7.2%. Hence, underlying inflationary pressures remain broad based and persistent in the US economy. As a result, the bar for the Fed to stop hiking rates is very high. Last week, FOMC member Christopher Waller stated that he would need to see month-on-month core inflation prints of around 0.2% for a period of five to six months before he is comfortable with backing off on rate hikes. In the past three months, the monthly rates of various measures of underlying core inflation have ranged between 0.5-0.65%. Even though oil and food prices have relapsed and freight rates have plunged, US core inflation has still surprised to the upside. The point being is that core inflation is neither about oil and food prices nor is it about the prices of other individual items. We have been arguing for some time that the key variables to watch to determine whether inflation will be persistent are wages and unit labor costs. US wage growth is elevated, and unit labor costs are soaring (Chart 2). Finally, companies have raised prices at an annual rate of 8-9% (Chart 3). Chart 2US Labor Costs Have Been Surging US Labor Costs Have Been Surging US Labor Costs Have Been Surging Chart 3US Companies Have Raised Prices At An 8-9% Annual Rate US Companies Have Raised Prices At An 8-9% Annual Rate US Companies Have Raised Prices At An 8-9% Annual Rate     US Stagflation Or Recession? Is the US economy heading into stagflation or recession? How persistent will US inflation prove to be? Over the next several months, US core inflation will prove to be sticky. So, stagflation (weak real growth and high inflation) is the likely outcome over the near term. Beyond this period, say on a 12-month horizon, the US economic outlook is less clear.   Chart 4US Corporate Profit Margins Have Peaked US Corporate Profit Margins Have Peaked US Corporate Profit Margins Have Peaked One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that margins are already rolling over (Chart 4). Hence, business owners and CEOs will attempt to raise selling prices further. This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral could unravel. The Fed will have to raise rates by much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and respond by curtailing their purchases, then sales and output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge. Suffering a profit squeeze, companies will lay off employees, and wage growth will decelerate sharply. Although bond yields will drop significantly, the benefit to equities will be offset by plunging corporate profits. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor. Bottom Line: Inflation is an inert and persistent phenomenon. The inflation genie has escaped from the bottle. When this happens, it is hard to put the genie back. In short, unless the US economy experiences a recession, core inflation will not drop below 3.5%. Still On A Collision Course On February 18 of this year, we published a piece titled A Collision In The Fog Of Inflation?, arguing that the Fed and the US equity market are on a collision course amidst the fog of inflation. Specifically, we noted that “the Fed will not make a dovish pivot until markets sell off, and markets cannot rally unless the Fed backs off.” This reasoning still applies. Barring a major US growth slump, US core inflation will not drop below 3.5%. Hence, the only way for the Fed to bring core inflation toward its 2% target is to tighten policy further. Financial conditions play a critical role in shaping the trajectory of the US economy. US domestic demand might not weaken sufficiently and, hence, US core inflation will not subside below 3.5% unless financial conditions tighten further (Chart 5). That is why a scenario in which US stocks and bonds rally despite the Fed’s continuous tightening is currently unlikely. Presently, there seems to be a dichotomy between the signal from the US yield curve and share prices. Despite the extremely inverted yield curve, US share prices have not yet fallen to new lows (Chart 6). Chart 5US Financial Conditions Have Room To Tighten Further US Financial Conditions Have Room To Tighten Further US Financial Conditions Have Room To Tighten Further Chart 6The US Yield Curve Is In An Equity Danger Zone The US Yield Curve Is In An Equity Danger Zone The US Yield Curve Is In An Equity Danger Zone Chart 7A Negative Bond Term Premium Amid High Volatility Is Paradoxical A Negative Bond Term Premium Amid High Volatility Is Paradoxical A Negative Bond Term Premium Amid High Volatility Is Paradoxical If US share prices do not break below their June lows, US interest rate expectations will rise further. The basis is that the Fed will not cut rates next year unless the economy is in recession and equities are selling off. In addition, there is a paradox in US long-term bonds. Despite exceptional inflation volatility, the Fed’s QT (reducing its bond holdings) and heightened US bond volatility, the US Treasurys’ term premium − the risk premium on bonds − is close to zero (Chart 7). That is why we expect the US bond market’s selloff to persist with 30-year yields pushing toward 4%. Consequently, US share prices will likely break below the major technical support that held up in the past 12 years (Chart 8). If the S&P 500 breaks below its June low, the next technical support is around 3200. Meanwhile, the US dollar will continue overshooting, as we argued in our recent report. Chart 8The S&P 500: Between Support And Resistance Lines The S&P 500: Between Support And Resistance Lines The S&P 500: Between Support And Resistance Lines Chart 9The EM Equity Index Is Still Above Its Long-Term Technical Support The EM Equity Index Is Still Above Its Long-Term Technical Support The EM Equity Index Is Still Above Its Long-Term Technical Support As for EM share prices, they will likely drop another 13-15% to reach their long-term technical support, as illustrated in Chart 9. Bottom Line: The Fed and the US stock market, and by extension global risk assets, remain on a collision course. A Global Manufacturing Recession Is Looming The latest data have corroborated our theme that global manufacturing and trade are heading into recession: Korean and Taiwanese manufacturing PMI new export orders have plunged well below the important 50 lines (Chart 10). Chinese imports for re-export are already contracting. They lead Chinese exports by three months (Chart 11). Chart 10Global Manufacturing / Trade Will Contract Global Manufacturing / Trade Will Contract Global Manufacturing / Trade Will Contract Chart 11Chinese Exports Are About To Shrink Chinese Exports Are About To Shrink Chinese Exports Are About To Shrink Chart 12Emerging Asian Currencies And Global Cyclicals-To-Defensives Stock Performance Emerging Asian Currencies And Global Cyclicals-To-Defensives Stock Performance Emerging Asian Currencies And Global Cyclicals-To-Defensives Stock Performance Chinese import volumes will continue shrinking, and EM ex-China domestic demand will relapse following the ongoing monetary tightening by their central banks. Finally, Emerging Asian currencies have been plunging, and such rapid and large-scale depreciation is a precursor to a global trade/manufacturing recession (Chart 12). Bottom Line: The imminent global trade contraction is bad for EM stocks and currencies as well as global cyclicals. Investment Strategy A hawkish Fed amid a global trade/manufacturing recession is producing a bearish cocktail for EM currencies and risk assets. Absolute-return investors should stay put on EM risk assets. Continue underweighting EM in global equity and credit portfolios. Emerging Asian currencies have more downside given the budding contraction in their exports and the interest rate differential moving further in favor of the US dollar. Commodity prices and commodity currencies remain at risk from the global manufacturing recession and the absence of a revival in Chinese demand. Overall, the US dollar will overshoot in the near term. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we continue to recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. EM currency depreciation will cause EM credit spreads to widen. Odds are that EM sovereign and corporate bond yields will rise, which is a bearish signal for EM non-TMT stocks, as illustrated in Chart 13. Chart 13EM USD Bond Yields Are Instrumental For EM Share Prices EM USD Bond Yields Are Instrumental For EM Share Prices EM USD Bond Yields Are Instrumental For EM Share Prices Chart 14Beware Of A Breakdown in EM Tech Stocks Beware Of A Breakdown in EM Tech Stocks Beware Of A Breakdown in EM Tech Stocks EM technology stocks are also breaking down. The share prices of TSMC, Samsung and Tencent have all fallen below their long-term technical supports (Chart 14). This negative technical profile coupled with our fundamental assessment point to a further slide in these share prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Figure 2The Net Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph.  Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph!  The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Assessing the future scenarios discounted in asset prices is always a challenge, but investors need a consensus baseline so they can formulate their own investment strategy decisions. The conversations we had at BCA’s annual investment conference last week reinforced our view that investors are overly pessimistic about corporate earnings prospects. Fears about runaway compensation growth are unfounded. The money markets, on the other hand, appear to be overly blasé about the fed funds rate. We think terminal rate expectations will have to be revised higher and that investors will have to wait longer for rate cuts than the OIS curve currently projects. Margins Have Peaked, But They're Still High Margins Have Peaked, But They're Still High Margins Have Peaked, But They're Still High Bottom Line: We remain more optimistic than the consensus over the immediate term and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are more cautious about the twelve-month outlook and recommend neutral positioning over that timeframe. Feature BCA held its first in-person conference in three years last week at The Plaza Hotel in New York. The agenda offered attendees a smorgasbord of thought-provoking discussions with recognized experts inside and outside of BCA. We enjoyed the programmed content as well as the impromptu interactions with speakers, attendees, our colleagues and the financial media. Again and again, our unplanned conversations homed in on questions about the expectations embedded in stock prices and bond yields. The future scenarios that securities prices are discounting cannot be directly observed and therefore can never be known definitively in real time. If investors do not continuously approximate them, however, they will be unable to evaluate the likelihood that actual outcomes will be better or worse than expected. Our view that markets and the economy can surprise on the upside has been built on the idea that expectations are overly gloomy. That is still our view on balance, as we think the S&P 500 is pricing in a worse near-term earnings outlook than is likely to occur, though we expect the Fed to surprise markets hawkishly before this rate hiking cycle ends. The combination of positive earnings surprises over the next few quarters and a negative monetary policy surprise coming sometime by the second half of next year leaves us optimistic about risk assets over the next six months but wary of them over the next twelve months and beyond. Earnings The analyst consensus currently estimates that S&P 500 earnings per share over the next four quarters will exceed the second quarter’s annualized run rate by just 0.3% and the trailing four quarters by 5.5% (Table 1). Modest as those expectations may be, we do not sense that investors are counting on them. Financial media reports and our discussions with clients and colleagues suggest that investors are braced for peak-to-trough earnings declines in the double digits, consistent with past recessions (Chart 1). Those bandying about estimates of a 10-20% decline are not necessarily calling for them to occur in the next four quarters, but we think it is clear that the forward S&P 500 whisper number is below the official I/B/E/S consensus. Table 1The Official Bar Is Low, The Whisper Bar Is Lower What Are Markets Discounting? What Are Markets Discounting? Chart 1Recessions Are Hard On Earnings Recessions Are Hard On Earnings Recessions Are Hard On Earnings For nominal earnings growth to miss such meager expectations while inflation is high, profit margins will have to contract sharply, but we would also expect declining revenues to play a major role, as in the 2001 and 2007-2009 recessions (Chart 2). That expectation follows from our view that nominal GDP growth is a solid proxy for S&P 500 sales growth (Chart 3), with nominal GDP explaining 41% of the variation in S&P 500 sales since 1997 (64% correlation). Nominal GDP grew at close to a 10% clip in the first half, and if inflation is around 6% in the second half, we would expect 8% growth over the next two quarters and about 6% growth in the first half of next year.1 Chart 2Sales Fall In Downturns, Too Sales Fall In Downturns, Too Sales Fall In Downturns, Too Chart 3As Goes GDP, So Go Corporate Revenues As Goes GDP, So Go Corporate Revenues As Goes GDP, So Go Corporate Revenues Despite the revenue buffer provided by 7% nominal GDP growth, we expect S&P 500 profit margins will extend their decline from the 2Q21 peak (Chart 4). Investors nearly unanimously expect that margins are imperiled, but we are more sanguine about the pace of the decline than the consensus and suspect the difference comes down to the pace of wage growth. Compensation is the largest expense category by a wide margin and has the capacity to move the aggregate margin needle on its own. Just as the US growth outlook may rest on consumption, compensation may be the key to margins’ future path. Chart 4A Slower-Than-Expected Decline A Slower-Than-Expected Decline A Slower-Than-Expected Decline Much has been made of the shortage of available workers and its impact on wages, which are rising at the fastest pace in decades (Chart 5). In real terms, however, wage growth has been deeply negative ever since frontline workers stopped receiving hazard pay early in the pandemic (Chart 6). Real wages should find a footing as inflation cools and may eventually break into positive territory, but rampant talk of a wage-price spiral suggests that the consensus is factoring in much more. We think the prospects of a wage-price spiral like the one in the late seventies are being dramatically overestimated. Chart 5The Nominal Gains Have Been Great ... The Nominal Gains Have Been Great ... The Nominal Gains Have Been Great ... ​​​​​ Chart 6... But They're Way Behind Consumer Prices ... But They're Way Behind Consumer Prices ... But They're Way Behind Consumer Prices ​​​​​ We will not revisit the rationale for our wage-price spiral view in detail, but it is founded on the notion that workers’ current advantage, even if it were to persist for the rest of the Biden administration’s term, will not be sufficient to offset four decades of employers’ structural gains. Labor surely has the upper hand from a cyclical perspective – demand for workers exceeds supply – but we do not think it can convert its near-term advantage into durable gains. Private sector union membership has dwindled from over 30% at its mid-sixties peak to less than 7% today, leaving workers badly outgunned when trying to assemble a sellers’ cartel to counter the formidable buyers’ cartel enabled by 40 years of lax anti-trust enforcement. Even the “most pro-labor president leading the most pro-labor administration you’ve ever seen” isn’t likely to be able to counter several decades of weakened state-level labor protections.2 History says that employers will take as hard a line with their employees as is socially acceptable and what is deemed kosher has moved so far in their favor since President Reagan crushed the air traffic controllers’ union early in his first term that the seventies template does not apply. Monetary Policy If the earnings mood is unduly glum, however, it would seem to be offset by what strikes us as unfounded expectations that the Fed will stand down from its inflation fight before too long. Perhaps BCA strategists are a bit too credulous, but we are inclined to take the Fed at its word that, as former Vice Chair Richard Clarida put it at the conference, “failure [to subdue inflation] is not an option.” While we side with the consensus in our expectation that inflation will soon recede to 4% of its own accord as COVID bottlenecks are cleared, we judge that monetary and fiscal policymakers overstimulated aggregate demand in their efforts to shelter the economy from the pandemic. As a result, we expect that the Fed will have to administer much harsher monetary medicine to achieve its inflation mandate than markets are currently discounting. We have two objections to the money market’s fed funds rate expectations as derived from the overnight index swap curve (Chart 7). We think the fed funds rate will peak well north of 4% in this hiking cycle and there is almost no chance that the Fed will cut rates at any point in 2023. While markets have gotten more realistic about the monetary policy path than they were after the FOMC’s July meeting, we think they are still clinging to a vain hope. All financial assets will have to be repriced once it is snuffed out, and that repricing represents a significant risk to our constructive six-month view if it occurs before underweight asset managers are forced back into risk assets to protect their funds’ relative performance. Chart 7Magical Thinking Magical Thinking Magical Thinking The wide range of views about the neutral, or equilibrium, rate that demarcates the line where the fed funds rate flips from accommodative to restrictive explains the terminal rate uncertainty. The neutral rate cannot be directly observed and everyone from investors to central bankers is left to infer its location from the variables that they can see. We think the neutral rate is north of 4%, possibly as high as 4.5-5%, especially given our view that inflation will likely linger at 4%. New York Fed president John Williams suggested in a Wall Street Journal interview two weeks ago that it may be in the mid-3s. “We need to get the interest rate, relative to where inflation is expected to be over the next year, into a positive space and probably even higher.” The article said Williams expects inflation to range between 2.5 and 3% next year, suggesting that the real funds rate is on course to turn positive this fall. Melting one-year inflation expectations as implied by TIPS break-evens suggest that it’s been rising in sizable chunks week after week since the FOMC’s July meeting (Chart 8). We would take the over on Thursday’s 1.71% close if only it were available on New York’s newly legalized online sports books but someone who does expect sub-2% inflation next year might logically conclude that the Fed will be cutting rates soon. Chart 8Garbage In, Garbage Out Garbage In, Garbage Out Garbage In, Garbage Out Investment Implications Our conversations at the conference and its margins left us essentially where we began. We think investors are underestimating the economy’s ability to grow at a rate that will support continued corporate earnings growth over the next four quarters, albeit at a decelerating rate. On the other hand, we think markets face a reckoning when they are forced to price in a longer and more extensive rate hiking campaign than they currently expect. We square the circle from an investment strategy perspective by conditioning our views on investor timeframes. Because we think the earnings whisper numbers will be meaningfully revised higher before monetary policy expectations are reset more hawkishly, we remain tactically bullish. If rate expectations were to reset sooner than we currently expect (sometime early next year), our tactical call would be at significant risk and we would likely become as cautious over the six-month timeframe as we are over the twelve-month timeframe. As it stands now, we continue to recommend overweighting equities in balanced portfolios over the next six months while pursuing neutral risk asset positioning over timeframes of twelve months or more.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Our nominal growth expectations assume the US economy maintains real growth at close to its 2% trend level, as consumption is supported by households’ considerable excess savings, but we do not repeat our case here. 2     The weather is fine, and the Saturday football unmatched, but it is flimsy labor protections that drew Boeing’s Dreamliner assembly work and a slew of foreign automakers to the Southeastern Conference’s legacy Deep South footprint and the other states competing for good factory jobs have taken notice.

Executive Summary Central banks are aggressively tightening policy around the world. Their ability to rein in inflation without causing a recession depends upon the level of the real neutral rates. Australia, Canada, New Zealand, and Sweden have elevated r-stars, but the picture changes drastically when their large debt loads are factored in. While real policy rates remain below r-star across DM economies for now, a more rapid decline in supply-driven inflation would correct this situation. Consequently, a global recession does not constitute our base case for the next six months, although it is a growing threat. The ECB is front-loading interest rate increases while it can, but the destination of travel is not changing significantly. Global R-Star Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The global r-star varies greatly around the world and debt sustainability concerns weigh on the real neutral rates of Australia, Canada, New Zealand, and Sweden. The US economy remains best capable of handling higher interest rates.   Chart 1Rising Global Inflation Rising Global Inflation Rising Global Inflation Inflation around G10 economies has been very strong and much more durable than originally hoped. As a result, inflation now averages 7.1% on a headline CPI basis and 4.6% based on core CPI across among G10 economies (Chart 1). Central banks are tightening policy aggressively to prevent this elevated inflation from becoming entrenched. Essentially, they are aiming to avert the emergence of the kind of inflationary mentality that prevailed in the 1970s, which caused stubborn inflation during that decade. This exercise is fraught with difficulty. The objective is to achieve a policy setting that is slightly above the neutral rate of interest, but not too much so. On the one hand, keeping policy too accommodative will increase the chances that an inflationary mentality will emerge; on the other hand, if policy is tightened too much, a recession will become unavoidable and deflationary risks will escalate. A sense of where the neutral rate for major economies lies is therefore necessary to draw that line in the sand. To do so, we estimate the real neutral rate of interest for major DM economies using the methodology we introduced seven weeks ago, when we evaluated the neutral rates for the major Eurozone economies. This exercise shows that, at the current level of interest rates and inflation, policy among major economies remains accommodative. However, if inflation decelerates sharply in the coming months in response to declining global supply constraints and lower commodity prices, the recent increase in policy rates will have already gone a long way to normalizing monetary policy around the world. A Simple Approach The methodology we use is based on the approach developed by Holston, Laubach, and Williams (HLW)  to estimate the neutral real interest rate – or “r-star.” Specifically, we run regressions between the real interest rates in the US, Japan, the UK, New Zealand, Canada, Australia, Sweden, and Switzerland versus trend GDP growth and current account balances, which approximate the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average of core CPI.1  Table 1Unadjusted R-Stars Neutral Rates Around The World Neutral Rates Around The World The results are shown in Table 1. New Zealand, Australia, and Canada have the highest real-neutral rate of the major economies. They have had stronger growth over the past 20 years because of their rapid population growth caused by high immigration rates. Moreover, their commodity-based economies and their booming construction sectors pushed up investment rates, which requires high interest rates to attract sufficient savings to finance. Sweden and the US follow. These two economies have lower population growth rates than the commodity producers; nonetheless, they outperform Japan and the other European nations in the survey on that dimension. Moreover, they fare comparatively well in terms of productivity growth, which implies that their trend growth – a key driver of the neutral rate – is also higher than that of the UK, Japan, Switzerland, or the Euro Area. The US’s r-star shows up as being slightly below what would be expected based on its potential GDP growth. This surprising outcome most likely reflects the role of the dollar in global FX reserves and its standing at the core of the global financial system. These two characteristics of the greenback create an important demand for dollar-denominated assets that is dissociated from US domestic economic fundamentals. This additional demand biases downward the US real neutral rate and suggests that weak trend growth abroad and global excess savings remain important forces for US financial markets. Chart 2Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan displays a surprisingly elevated real neutral rate of 0.1%. This result reflects the limitation of the approach. Japanese interest rates have been at zero since the late 1990s and real rates have been negatively correlated with inflation because of this nominal rigidity (Chart 2). However, while Japanese inflation has averaged a paltry 0.2% since 1997, it has nonetheless fluctuated with commodity prices and global economic activity. As a result, real rates have been essentially dissociated from Japanese domestic drivers. Hence, an empirical approach based on the evolution of domestic economic variables yields poor results for Japan. Instead, the lack of inflation when public debt has increased by 200% of GDP over the past 32 years and Japan’s large net international investment position imply that its r-star is inferior to that of the other countries in the sample, and thus should lie below -1%. For the Eurozone, we use the average result of our July study, which estimated the neutral rates of Germany, France, Italy, and Spain independently. Germany flatters this estimate since its real neutral rate stands near 0%. An average, excluding Germany, would be closer to -0.5%, or well below the US r-star. Meanwhile, the Swiss r-star is depressed by both a low population growth and the Swiss exceptional savings generation, as highlighted by its current account surplus that has averaged 8% of GDP over the past 20 years. Finally, the UK’s r-star stands at the bottom of the pack. The UK’s productivity growth has been very poor over the past ten years, averaging 0.7% per annum. This points to a weak potential GDP for that economy. Moreover, the hurdles to UK growth have only increased in recent years with the implementation of Brexit, which is hurting the availability of labor in the country, while putting the UK at an even greater disadvantage in European markets, its largest export destination. What About Debt? This approach to estimating r-star ignores a key dimension: debt sustainability. If we factor in this crucial variable, the level of interest rates causing economic activity to decelerate changes drastically for many countries. Chart 3Massive Real Estates Bubbles Massive Real Estates Bubbles Massive Real Estates Bubbles Since 2000, real estate prices have surged by 280%, 220%, 170%, and 200% in New Zealand, Canada, Australia, and Sweden, respectively. These gains dwarf the house price appreciation observed in the US, the UK, Japan, or Germany (Chart 3, top panel). This outperformance of house prices is particularly problematic because it does not reflect more rapid underlying cash-flow growth from the assets. Instead, the main driver of the stronger house prices in New Zealand, Canada, Australia, and Sweden has been the explosion of their price-to-rent and price-to-income ratios (Chart 3, bottom two panels). Rising real estate prices boosted economic activity relative to the underlying trend GDP of these countries. As a result, the long-term growth numbers of these four nations potentially overstate their underlying rate of growth. Even more importantly, real estate prices and activity are extremely sensitive to interest rates. Therefore, the risk of bursting bubbles in New Zealand, Canada, Australia, and Sweden limits how high interest rates may rise there without causing growth to plunge and deflationary spirals to emerge. Chart 4Rapidly Rising Debt Loads Rapidly Rising Debt Loads Rapidly Rising Debt Loads The accumulation of debt in these four countries accentuates the threats to growth created by real estate activity. The private-sector debt of New Zealand, Canada, Australia, and Sweden has risen much more quickly than has been the case in Germany and the US (Chart 4). Ultimately, these debt burdens create major headwinds against higher interest rates and suggest that the effective r-star of these nations lies well below the estimates constructed using only trend growth and the savings/investment balance. Table 2Drastic Changes Once Debt Is Accounted For Neutral Rates Around The World Neutral Rates Around The World To account for the private-sector leverage, we estimated new debt-adjusted r-stars. The impact of high debt loads on r-star estimates is evident in Table 2. The average real neutral rate of New Zealand, Australia, and Canada drops from 1.9% to -1.9%. In fact, Australia and Canada would sport the lowest r-star estimates of the nations under study. Sweden’s neutral rate also experienced a big decline from 0.6% to 0.2%. The US r-star estimate is also lowered by the addition of debt metrics in its equation, declining from 0.2% to -0.4%. The Eurozone average r-star experiences a significant decrease as well, driven mostly by Spain and France. The Swiss economy also sports a large private debt load, and its r-star is therefore curtailed from -0.75% to -1.3%. Finally, Japan’s r-star estimate barely changes, which confirms that the approach does not work well for that country. The greatest drawback of the method is that it is backward-looking. The main force that has brought down the global r-star over the past 20 years is the collapse in trend growth among most advanced economies (Chart 5). Consequently, neutral rates could improve from their current low levels if trend growth were to pick up in the coming years. On the positive side, the current age of the capital stock in both Europe and the US is extremely advanced (Chart 6), which suggests that a capex upturn is likely. Such an upturn would boost productivity and lift the r-star among most major economies. On the negative side, the growth of human capital is deteriorating as educational attainment stalls among most DM nations. The decline in the growth rate of human capital is a large threat to productivity over the coming decades. These problems are magnified in the Eurozone, as its high degree of economic fragmentation, lack of common fiscal policy, and higher regulatory burden create further handicaps to trend growth. Chart 5R-star And Global Growth R-star and Global Growth R-star and Global Growth Chart 6A Capex Revival? A Capex Revival? A Capex Revival? Bottom Line: Estimating the real neutral rates for the global economy often relies on trend growth and the savings/investment balance. However, such an approach often misses the vulnerability to higher interest rates created by high private-sector indebtedness. If this constraint is considered, the high r-star recorded in countries like New Zealand, Australia, or Canada is reduced dramatically. The US r-star also declines but significantly less so. As we already showed seven weeks ago, the same phenomenon is also visible in the Eurozone, albeit driven by France and Spain, not Germany or Italy. Investment Implications There are three main conclusions from the analysis above. First, the risk of a financial accident in commodity-producing economies is growing increasingly large. On the one hand, economies like New Zealand, Australia, and Canada are buoyed by the recent surge in commodity prices, with agricultural prices up 90% since their 2020 lows, metal prices up 68%, and energy prices up 340% since April 2020. On the other hand, the inflationary pressures created by robust commodity sectors invite the RBNZ, the RBA, and the BoC to lift interest rates quickly, which is hurting massively indebted private sectors. Already, in response to the 275bps and 300bps of hikes implemented by the RBNZ and the BoC, house prices in New Zealand have begun to buckle, down 12% and since their more recent peaks, and they are expected to plunge by as much as 25% in Canada by the end of next year. Chart 7NZD And CAD At A Disadvantage Neutral Rates Around The World Neutral Rates Around The World This suggests that non-commodity equities in Canada, Australia, and New Zealand, especially financials, could experience significant periods of underperformance, both against their domestic equity benchmark and global market averages. Additionally, while the NZD, AUD, and CAD all benefit from improving terms of trades, the potential for domestic weakness is such that these currencies are likely to lag their historical sensitivity to commodity price fluctuations. In fact, according to BCA’s foreign exchange strategist, the New Zealand and Canadian dollars are among the most expensive currencies in the G10 (Chart 7), and thus, it is likely to underperform other pro-cyclical currencies once the USD bull market reverses. Second, the neutral rate in the US has risen by 200bps relative to the rest of the world over the past seven years. The US economy has undergone a long deleveraging period in the wake of the GFC, which means that its private-debt-to-GDP ratio has declined relative to other advanced economies. Consequently, the vulnerability of the US economy to higher interest rates has decreased, even if relative US trend growth has not improved meaningfully. The market implications of this pickup in the neutral rate are manifold. To begin with, it allows US rates to rise further relative to other DM economies. BCA’s Global Fixed Income Strategy team continues to underweight US Treasurys in global fixed-income portfolios, especially relative to German Bunds (Chart 8). As a corollary, it also means that US financials are likely to continue to outperform their foreign peers, especially Canadian and Australian ones which will bear the brunt of the negative consequences of their debt bubbles. The increase in the US r-star relative to the rest of the world has been a key contributor to the dollar rally. It helps explain why the recent dollar strength has not hurt relative profit growth (Chart 9). However, the dollar is trading at a 32% premium to its purchasing power parity, or the same overvaluation as in 1985 and 2001. Thus, with the worsening US balance of payment picture, the US dollar is vulnerable to an eventual improvement in global growth next year. Chart 8US Rate Differentials Have Upside Neutral Rates Around The World Neutral Rates Around The World Chart 9The US Fares Better The US Fares Better The US Fares Better Chart 10Easy Or Not? Easy Or Not? Easy Or Not? Finally, despite the recent increase in rates, the high level of inflation recorded around the world implies that real policy rates are still well below r-star for major global economies, whether one uses actual inflation or the smooth formulation recommended by the HLW paper (Chart 10). This suggests that a recession is unlikely, especially in the US. The recession threat is higher in Europe but has little to do with policy. It is mostly a consequence of the massive terms of trade shock caused by the sudden jump in European energy prices in the wake of the Ukrainian war. However, because policy remains accommodative even in Europe, it follows that the Eurozone economy will rebound quickly once the worst of the energy shock is over next spring. Some humility is required. It is hard to gauge how much of the inflation surge over the past 18 months reflects supply factors. If inflation suddenly becomes much weaker because the easing in supply constraints has a greater-than-anticipated impact on inflation, real interest rates would jump rapidly around the world. In this scenario, policy rates could rise quickly and overtake r-star. This would mean that the disinflation impulse could rapidly morph into an outright deflationary environment, which implies that the odds of a deflationary bust like the one experienced in 1921 is greater than the market currently prices in.  Bottom Line: The debt-fueled real estate bubbles in the dollar-bloc economies suggests that they are at a greater risk of a financial accident than the US or the Eurozone. As a result, their financial sector looks vulnerable. Meanwhile, the higher US r-star compared to that of the rest of the world will continue to support higher yields in the US rather than in Europe or Japan. This phenomenon has been hugely positive for the US dollar, but it has likely run its course. Finally, global real interest rates remain below r-star estimates. Hence, the current slowdown is likely to prove to be a mid-cycle slowdown and Europe will rebound quickly from a potential recession caused by the recent surge in its energy prices. The ECB Joins The 75bps Club Last week, the ECB increased interest rates by 75bps, which brought its deposit rate to 0.75%. Interestingly, the euro did not rally much in response to this policy decision, even though it has not been fully discounted by the market. At first glance, the lack of responsiveness from European assets seems strange, especially since the vote for a 75bps rate hike was unanimous. The ECB is taking advantage of strong economic numbers to push up rates rapidly. The Eurozone Q2 GDP growth was robust at 0.6%, while the unemployment rate hit an all-time low of 6.6%. Meanwhile, inflation continues to beat consensus forecasts, with Eurozone core CPI and headline CPI standing at 4.3% and 9.1%, respectively in August. Chart 11Big ECB Revisions Big ECB Revisions Big ECB Revisions The market believes that more rapid interest rate hikes now will not translate into a much higher terminal rate, with the expected rates for June 2023 moving from 2.2% on September 7th to 2.4% after last Thursday’s decision. The ECB may have increased its inflation forecasts for the whole horizon, but it has also brought down GDP forecasts to 0.9% and 1.9% in 2023 and 2024, respectively (Chart 11). Moreover, ECB President Christine Lagarde went out of her way to telegraph to investors that the number of upcoming hikes was finite. The jumbo hike does not spell the start of a euro rally—for now. First, the lack of major change in the ECB’s terminal deposit rate is more important than the more rapid pace of hikes for the remainder of 2022. Second, the Fed is also lifting rates faster than investors expected ahead of the Jackson Hole meeting three weeks ago. Third, the euro remains vulnerable to any flare-ups in the energy market. True, natural gas and electricity prices have recently fallen, but the situation in Ukraine continues to be highly fluid, which suggests that volatility will linger in the energy market over the coming weeks.   Despite the near-term hurdles, the euro’s medium-term outlook is brightening. We are gaining confidence in our thesis that energy prices will peak once natural gas inventories have reached approximately 90% by November. Additionally, the support of the Governing Council’s doves for a 75bps hike suggests that they received something in exchange for their votes. In our view, this “something” is an activation of the Transmission Protection Instrument (TPI) before year-end. The TPI activation will allow for a normalization of the risk premia in the Italian debt market and will support the ECB’s ability to increase interest rates further down the road, despite the much lower r-star in Italy, Spain, and France than in Germany (Table 3). Table 3The Eurozone’s Different R-Stars Will Force The TPI’s Activation Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The ECB may have delivered a jumbo hike last week, but its market impact was muted. Investors understand full well that the ECB is taking advantage of the recent bout of robust economic activity to front-load interest rate increases ahead of a likely economic contraction in Q4 2022 and Q1 2023. As a result, the terminal rate estimates have scarcely moved. Ultimately, we expect the ECB deposit rate to settle between 1.5% and 2% in the summer of 2023. While the move may not provide much of a boost to the euro in the near term, conditions are falling into place for a euro rally later this year.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1     For the US, we opted for core PCE, since it is the benchmark inflation measure the Federal Reserve uses.

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 7Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued The Euro Is Undervalued The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing? Special Trade Recommendations Current MacroQuant Model Scores Inelastic Supply: The Secret To A Soft Landing? Inelastic Supply: The Secret To A Soft Landing?      

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 ...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 The Peak In Core PCE Inflation In February 2022 The Peak In Core PCE Inflation In February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 ...Aligns With The Peak In Core PCE Inflation In January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next Markets Still Echoing 1981-82, So Here’s What Happens Next 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary The US dollar has become expensive, but it is not unusual for currencies to overshoot or undershoot their fair value. Valuation is not an effective market timing tool. In the US, high interest rates and a strong exchange rate are needed to bring down inflation. The US dollar will remain firm as long as the Fed maintains its credibility in the fight against inflation. China needs lower interest rates and a weaker currency to battle deflationary pressures. The PBoC will continue cutting interest rates. Persistent divergence between Chinese and US monetary policies heralds further yuan depreciation against the dollar. For a number of EM countries, exchange rate fluctuations have historically determined trends in their interest rates rather than the other way around (i.e., interest rates dictating EM currency trends). Shrinking global trade will boost the US dollar while EM currencies will depreciate further. The US Dollar Is Expensive But Could Still Overshoot The US Dollar Is Expensive But Could Still Overshoot The US Dollar Is Expensive But Could Still Overshoot Bottom Line: We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Macro forces that are bullish for the US dollar are bearish for global equities and other risk assets. A defensive investment stance is still warranted. Feature The US dollar is now in expensive territory (Chart of the week above) but we maintain our view that the US dollar is poised to overshoot. Chart 1EM Currencies Are Breaking Down EM Currencies Are Breaking Down EM Currencies Are Breaking Down BCA’s Emerging Markets Strategy team has been structurally bullish on the US dollar since 2011, with a brief period during which we sidestepped our positive view from July 9, 2020 until late March 2021 (Chart 1). We then re-instated short positions in select EM currencies versus the US dollar on March 25, 2021. This strategy has paid off. In this report, we discuss reasons why we expect the greenback to continue overshooting in the near run. Currency Valuations In Appendix 1 we present our valuation models for various currencies using the real effective exchange rate (REER) based on unit labor costs. In our opinion, the REER based on unit labor costs is the most accurate measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component for many companies, and unit labor costs are critical to competitiveness. Hence, this measure is superior to the ones based on CPI and PPI. Table 1Currency Valuation Ranking Using Real Effective Exchange Rate Based on Unit Labor Costs* The US Dollar Will Overshoot, EM Currencies Will Undershoot The US Dollar Will Overshoot, EM Currencies Will Undershoot The underlying data for the REER based on unit labor costs are from the IMF and OECD. Unfortunately, the IMF and OECD do not provide REER based on unit labor costs for many emerging economies. Appendix 1 contains valuation indicators for those EM exchange rates (MXN, CLP, COP, KRW, SING, PLN, HUF and CZK) for which IMF or OECD data is available. Charts 15-17 in the appendix show that the US dollar is currently more than one standard deviation above its fair value. Meanwhile, the euro and yen are extremely cheap – each standing at more than one standard deviation below their respective fair value.   Table 1 shows the valuation ranking of various currencies using REER based on unit labor costs. For mainstream EM currencies, excluding China, Russia, Korea and Taiwan, we have built valuation aggregates using an average REER based on CPI and PPI measures. Chart 2 presents an equal-weighted aggregate REER based on CPI and PPI for 15 EM currencies. This indicator does not suggest that mainstream EM currencies are cheap. Finally, the same indicator − REER based on CPI and PPI – for the Chinese yuan reveals that the currency is modestly cheap (0.8 standard deviation below its mean) (Chart 3). Chart 2Mainstream EM Currencies Are Not Cheap Mainstream EM Currencies Are Not Cheap Mainstream EM Currencies Are Not Cheap Chart 3The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot The RMB Is Modestly Cheap But Might Undershoot   While we acknowledge that the US dollar is expensive, we continue to expect the greenback to overshoot over the coming months. First, valuations matter only at extremes. Most currencies (other than the yen and the euro) are not cheap. For example, Charts 21-24 (in the Appendix) demonstrate that commodity currencies including AUD, NZD, and NOK are on the expensive side, while the Canadian dollar is fairly valued. Second, our macro themes – a hawkish Fed and contracting global trade (discussed below) − call for a stronger greenback. Finally, our Foreign Exchange Strategy team has shown that momentum indicators work well for currency trading in the short term. Bottom Line: The US dollar has become expensive, but it is not unusual for currencies to overshoot or undershoot their fair value. Valuation is not an effective market timing tool. Presently, the US dollar's momentum is strong and it will likely continue supporting the currency's upward trajectory. Monetary Policy Divergence Chart 4US Core Inflation Is Well Above 2% US Core Inflation Is Well Above 2% US Core Inflation Is Well Above 2% The US economy is relatively less exposed to headwinds from rising interest rates than the rest of the world. This dynamic favors the US dollar against other currencies. US: We view US inflation as genuine and entrenched. The average of seven measures of underlying inflation remains very elevated at 5.5% (Chart 4). In the US, high interest rates and a strong exchange rate are needed to bring down inflation. As long as the Fed remains committed to bringing down inflation, the US dollar will be firm. The US dollar will plummet if the Fed turns dovish prematurely. The basis is that US inflation expectations will spike and real interest rates will tumble, which will weigh on the dollar. Although the Fed might eventually pivot earlier than needed, this policy shift is not imminent. China: In contrast with the US, China’s inflation is too low: core and services CPI inflation have rolled over and are below 1% (Chart 5). The mainland economy is extremely weak, and the property market is struggling. China needs lower interest rates and a weaker currency to battle deflationary pressures. The PBoC will continue cutting interest rates. Persistent divergence between Chinese and US monetary policies heralds further yuan weakness against the dollar (Chart 6). Chart 5China's Inflation Is Too Low And Falling China's Inflation Is Too Low And Falling China's Inflation Is Too Low And Falling Chart 6The CNY Will Depreciate Versus The USD The CNY Will Depreciate Versus The USD The CNY Will Depreciate Versus The USD     A weakening RMB versus the US dollar is typically associated with declining commodity prices (Chart 7). Falling commodity prices will weigh on commodity currencies. The yuan depreciation will also continue reinforcing the downtrend in emerging Asian currencies. Mainstream EM: For many emerging markets, interest rates do not explain fluctuations in their currencies. In developing countries that run current account deficits and/or rely on foreign capital, interest rates rise when their exchange rates plummet (Chart 8). Chart 7CNY Depreciation = Lower Commodity Prices CNY Depreciation = Lower Commodity Prices CNY Depreciation = Lower Commodity Prices Chart 8Interest Rates Do Not Drive EM FX Interest Rates Do Not Drive EM FX Interest Rates Do Not Drive EM FX   On the flip side, appreciating EM currencies unleash disinflationary pressures in their domestic economies, giving room for central banks to cut rates. Therefore, for EM economies that are dependent on global capital, it is exchange rates that have historically dictated interest rate dynamics, rather than the other way around. Continental Europe: The European economy is hamstrung by extremely high energy prices and rising interest rates. Importantly, wages in Europe are not rising as fast as they are in the US. Household real disposable income is falling faster in Europe than it is in the US. Plus, the continental European economy is more exposed than the US to global trade − which is about to contract (more on this below). Thus, the European economy has a reduced capacity to absorb higher borrowing costs vis-a-vis the US. Consequently, the real interest rate differential will continue moving in favor of the US, supporting the greenback versus the euro. The Anglo-Saxon block: The US economy will prove to be more resilient to higher borrowing costs than many other DM economies such as the UK, Australia, New Zealand and Canada. As a result, the interest rate differential will move in favor of the US dollar. Chart 9US Households Have Deleveraged US Households Have Deleveraged US Households Have Deleveraged In many of these countries, the household debt burden is higher than it is in the US. In fact, US consumer debt and debt servicing have fallen significantly over the past 15 years (Chart 9). Importantly, a considerable portion of outstanding mortgages in the UK, Australia, New Zealand and Canada have either a floating rate or a fixed rate for only a few years. As borrowing costs rise, consumer finances in these countries will experience material distress. By comparison, the majority of outstanding US mortgages are fixed for 30 years or so. Hence, rising borrowing costs hurt new American homebuyers but do not impact existing mortgage holders. Bottom Line: On a relative basis, the US is in a better position to absorb higher interest rates than many other economies. As a result, the interest rate differential will move in favor of the US over the rest of the world, hence, supporting the greenback in the near run. Shrinking Global Trade Is Bullish For The US Dollar The US dollar is a counter-cyclical currency, and it will continue to appreciate as the global manufacturing cycle slows (Chart 10).  The rationale is that manufacturing and exports constitute a smaller share of GDP in the US than in many other major economies. What if Fed over-tightening, causes a recession and pushes down US interest rates considerably? Would the US dollar plunge in this case? We do not believe so. Instead, a recession could be positive for the broad trade-weighted dollar. As US domestic demand and consumption shrink, its imports will also drop. The US dollar often rallies when the nation’s imports are contracting (Chart 11). Chart 10The US Dollar Is A Counter-Cyclical Currency The US Dollar Is A Counter-Cyclical Currency The US Dollar Is A Counter-Cyclical Currency Chart 11Shrinking US Imports = Rising US Dollar Shrinking US Imports = Rising US Dollar Shrinking US Imports = Rising US Dollar   Dwindling imports mean that the US will be emitting fewer dollars to the rest of the world. Global US dollar liquidity will continue to shrink, and the greenback will rally further, including against EM currencies (Chart 12). Bottom Line: As global trade shrinks, the US dollar will extend its rally. Mainstream EM Currencies In the long run, return on capital – not interest rate differentials – drive mainstream EM currencies. Chart 12 illustrates that EM currencies depreciate when their return on equity differential versus the US is negative and vice versa. In turn, the key driver of return on capital is productivity. Productivity growth has been downshifting across mainstream EMs since 2007 (Chart 13). Chart 12Tightening Global USD Liquidity = A Strong US Dollar Tightening Global USD Liquidity = A Strong US Dollar Tightening Global USD Liquidity = A Strong US Dollar Chart 13EM vs. US: Relative Return On Capital And Exchange Rates EM vs. US: Relative Return On Capital And Exchange Rates EM vs. US: Relative Return On Capital And Exchange Rates       Weak productivity growth and lower return on capital (versus the US) explain EM currency and equity underperformance since 2010. We have not yet detected a major change in EM fundamentals. Investment Strategy Chart 14Weak EM Productivity = EM Currency Depreciation Weak EM Productivity = EM Currency Depreciation Weak EM Productivity = EM Currency Depreciation The US dollar will overshoot in the near term. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. When the dollar appreciates it is neither the time to be long EM risk assets in absolute terms nor to be overweight EM in global equity and fixed-income portfolios. We continue underweighting EM in global equity and credit portfolios. EM local currency bonds offer value, but further currency depreciation and more rate hikes by their central banks are near-term risks to EM domestic bonds. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Appendix   Chart 15The US Dollar The US Dollar The US Dollar Chart 16The Japanese Yen The Japanese Yen The Japanese Yen Chart 17The Euro The Euro The Euro Chart 18The British Pound The British Pound The British Pound Chart 19The Swiss Franc The Swiss Franc The Swiss Franc Chart 20The Swedish Krona The Swedish Krona The Swedish Krona Chart 21The Norwegian Krone The Norwagain Krone The Norwagain Krone Chart 22The Canadian Dollar The Canadian Dollar The Canadian Dollar Chart 23The Australian Dollar The Australian Dollar The Australian Dollar Chart 24The New Zealand Dollar The New Zealand Dollar The New Zealand Dollar Chart 25The Korean Won The Korean Won The Korean Won Chart 26The Singapore Dollar The Singapore Dollar The Singapore Dollar Chart 27The Mexican Peso The Mexican Peso The Mexican Peso Chart 28The Chilean Peso The Chilean Peso The Chilean Peso Chart 29The Colombian Peso The Colombian Peso The Colombian Peso Chart 30The Polish Zloty The Polish Zloty The Polish Zloty Chart 31The Hungarian Forint The Hungarian Forint The Hungarian Forint Chart 32The Czech Koruna The Czech Koruna The Czech Koruna Footnotes   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)