Currencies

Dear Client, There will be no weekly report next week. Instead, we will host our quarterly webcast on Tuesday, October 26 for the US and EMEA regions and Wednesday, October 27 for the Asia Pacific region. We will resume our regular publishing schedule on Monday, November 1. In the meantime, we look forward to seeing many of you at our BCA Research Investment Conference this week. Best regards, Mathieu Savary   Highlights This year’s decline in EUR/USD has rendered this pair sufficiently inexpensive and oversold to account for the near-term risks we highlighted in March. Nonetheless, some risks remain—among them, the continued credit slowdown in China, diverging monetary policy trends, and the energy crisis hurting Europe. However, long-term fundamentals continue to support the euro’s 12- to 18-month outlook. Moreover, Chinese credit growth may soon stabilize and markets already largely factor in the policy divergence between the Fed and the ECB. As a result, we buy the euro today with a preliminary target at 1.25 and a stop loss at 1.1175. The Bank of England will lift rates this December, but the market already prices in a hawkish BoE. GBP/USD has upside, even if the euro should outpace the pound in the coming months. Look to upgrade UK small-cap stocks. Italian equities do not appear particularly appealing on a cyclical horizon, neither in absolute nor relative terms. Investors should favor Spanish stocks over Italian ones for the next 12-to-18 months. Feature EUR/USD recently flirted with 1.15. Did this move create a buying opportunity? Last March, we warned that the euro would correct to the 1.12 to 1.15 zone because short-term models flagged it as expensive, speculators carried a substantial net-long exposure, and Chinese credit growth was set to slow meaningfully. These forces have now mostly played out; thus, the euro’s near-term outlook is becoming more positive. Despite this more constructive view, EUR/USD still carries ample downside risks, especially if Chinese authorities remain reluctant to reflate their economy. Moreover, the energy crisis facing Europe clouds the euro. We are nonetheless buyers of EUR/USD, with a target at 1.25. Investors should set a wide stop in at 1.1175. Cheap And Oversold The internal dynamics of the euro indicate that the bulk of the sell-off is behind us. First, the euro is now cheap on a tactical basis. Back in March, our short-term fair value model for EUR/USD flagged at 7% overvaluation based on real rate differentials, on the slope of the German yield curve relative to that of the US, and on the copper-to-lumber prices ratio. Today, this same measure shows a 5% undervaluation. BCA’s Foreign Exchange Strategy Intermediate Term Timing Model (ITTM) flags an even clearer buy signal.  The ITTM framework combines interest rate parity models, with risk aversion and considerations for the currency’s trend. Currently, this model is at -8% or nearly minus one standard error. Historically, such a depressed reading points to generous returns in the subsequent 12 months (Chart 1). Second, the euro is oversold. BCA’s Intermediate Term Technical Indicator has hit 7, which is consistent with past rebounds in EUR/USD (Chart 2). While some of these rallies have been extremely short-lived, the technical indicator’s message is stronger when it is matched by a buy signal from the ITTM. Chart 1Strong Buy Signal From Short-Term Valuations Chart 2EUR/USD is Oversold Chart 3Stale Euro Longs Have Been Purged Third, speculators do not carry a large net long position in the euro anymore. This variable suggests that the worst of the selling pressure is behind us, but it has yet to send a strong buy signal on its own (Chart 3). Bottom Line: The euro is sufficiently inexpensive that our Intermediate-term timing model flags a strong buy signal. Moreover, our technical indicators paint an oversold picture consistent with a reversal. Nonetheless, speculators may not be long EUR/USD anymore, but they are not aggressively selling it either. Thus, macro dynamics remain important to the future trend of this currency. Macro Fog Remains The macro environment is not yet conducive to a euro rally, especially when Chinese credit growth remains weak. However, considering the euro’s valuation and technical picture, small changes in the macro environment could be enough to catalyze a jump in EUR/USD. A key problem for the euro is that the dollar remains well bid. The yen and the dollar are the two momentum currencies within the G-10 (Chart 4). This property of the dollar is a large handicap for the euro, because it remains the most liquid vehicle to bet on the USD. Thus, as long as the dollar’s momentum is strong, the euro will find it difficult to rally. Relative economic growth is another headwind for EUR/USD. European activity is weakening versus that of the US. Since 2019, the relative manufacturing PMIs between the Euro Area and the US track EUR/USD, and they currently confirm the euro’s weakness (Chart 5). Moreover, European economic surprises are significantly weaker than US ones, which adds to the euro’s malaise (Chart 5, bottom panel). Chart 4The Dollar Is A Momentum Currency Chart 5Deteriorating European Growth Hurts EUR/USD The near-term outlook does not signal a resolution of this issue until the first half of 2022. The declines in the expectation and current situation components of both the ZEW and Sentix surveys herald an additional deceleration in manufacturing activity (Chart 6). The Eurozone’s growth problems reflect China’s slowing credit flows. Europe economic activity is still extremely sensitive to the evolution of the global industrial cycle (Chart 7, top panel), much more so than the US GDP is. China’s business cycle is an essential determinant of the robustness of the global manufacturing sector. Consequently, when measures of China’s marginal propensity to consume decelerate, such as the gap between M1 and M2 growth, European PMIs and industrial production underperform those of the US (Chart 7, second and bottom panels). Chart 6A Bit More Time Before Europe's Slowdown Ends Chart 7China's Travails Hurt Europe     The fourth quarter of 2021 is likely to represent the tail end of the Chinese headwind on EUR/USD. The Chinese credit impulse remains weak, but signs of a floor are beginning to appear. For example, the decline in Chinese commercial banks excess reserve growth warned us of the coming decline in the credit impulse. Today, excess reserves have begun to stabilize, which points to an upcoming imporvement in credit flows (Chart 8). Additionally, the Evergrande problems continue to weigh on Europe in the near-term because of the deceleration in Chinese construction activity;  however, the crisis will also intensify the pressure on Beijing to revive credit growth in order to avoid a systemic collapse. Chart 8Will China's Credit Impulse Bottom Soon? Monetary policy differentials also remain euro bearish. The US Federal Reserve will announce the start of its tapering program on November 3. The FOMC is set to hike rates by the end of 2022. Meanwhile, the ECB is unphased by the increase in European inflation, which remains mostly a reflection of energy prices and base effects. Thus, Europe will lag behind the US when it comes to monetary policy tightening. Nonetheless, investors already understand this dichotomy very well. The US OIS curve anticipates four hikes in 2023. Meanwhile, the EONIA curve shows a first 25-bps hike only by September 2023. Thus, the euro will suffer more from policy differentials if the Fed generates hawkish surprises relative to this pricing. The energy crisis shaking Europe is the last major headwind currently affecting the euro. Historically, EUR/USD and the ratio of European to US natural gas prices track each other (Chart 9). This relationship reflects relative growth dynamics. A stronger Eurozone economy relative to the US pushes up the value of the euro and European natural gas, which is a commodity with heavy industrial usage.  However, since this summer, the spike in European natural gas prices has coincided with a decline in the euro. This divergence highlights the negative effect on European activity of the current energy shock, which raises fears of stagflation. The cross-Atlantic bond market dynamics confirm the notion that the energy shock increases the perceived stagflation risk in the Eurozone. German yields have risen relative to US ones because of a pick-up in inflation expectations, not real rates (Chart 10). The lack of traction for relative real rates is appropriate because market participants believe that the ECB wants to ignore the spike in energy prices. An environment of rising relative inflation expectations but stable relative real rates is very negative for any currency, including the euro. However, European inflation expectations should decrease relative to those of the US once European natural gas prices normalize, which we expect to take place in the coming months (Chart 10, bottom panel). This process will be very positive for the euro. Chart 9The European Energy Crisis Harms The Euro Chart 10Pricing In European Stagflation? Bottom Line: While euro pricing and technicals suggest EUR/USD will bottom soon, the economic environment is murkier. The dollar is a momentum currency, and its current strength feeds the euro’s weakness. China’s credit flows continue to decelerate, which hurts the euro; however, credit flows may stabilize in early 2022. The Fed is a tailwind for the dollar, but markets already price in this reality. Finally, the energy crisis hurts European growth and thus EUR/USD; nonetheless, the spike in natural gas prices will soon give way to a period of decline, which will lessen the pain for the euro. What To Do? When we balance the positives and negative for the euro, we are becoming more comfortable with buying EUR/USD outright, even if it is still a risky bet. To begin with, the big fundamental forces point to a firmer euro on an 18- to 24-month basis: BCA’s Foreign Exchange strategists see greater cyclical downside for the USD and believe the current rebound is a pronounced countertrend move within a multi-year dollar bear market. The euro will naturally benefit over the coming years from a weak greenback. EUR/USD is still inexpensive on long-term valuation metrics. Based on BCA’s purchasing power parity model, this pair trades 17% below its fair value. Moreover, the PPP estimate keeps rising in favor of the euro, a result of the Eurozone’s lower inflation compared to the US (Chart 11). The relative balance of payments favors the euro. The European economy generates a current account surplus of 3% of GDP compared to a current account deficit of 3.1% for the US. The US current account deficit is unlikely to narrow, even if the federal government’s budget hole declines because the private sector’s savings rate is falling even faster. Moreover, US real two-year rates remain well below those of its trading partners. Investors underweight Eurozone assets aggressively. For the past ten years, capital has consistently flowed out of the Euro Area relative to the US (Chart 12). European growth should converge toward the US next year, especially if Chinese credit activity stabilizes. Therefore, 2022 should witness a period of inflows into the Eurozone. Chart 11EUR/USD Significant Long-Term Discount Chart 12Investors Underweight Eurozone Assets We argued that the valuation and technical backdrop shows the Euro is becoming increasingly supportive and our timing model is clearly arguing against selling EUR/USD. However, the biggest technical risk is the momentum sensitivity of the dollar, which means that the euro’s weakness could last somewhat longer. Nevertheless, BCA’s Dollar Capitulation Index now warns of a pullback in the USD, especially as speculators are very long DXY futures (Chart 13). The biggest downside risk remains China’s credit trend. If it takes more time than we anticipate for Beijing to put an end to the credit impulse slowdown, the euro will experience greater downside pressure. Moreover, the longer it takes Beijing to reflate, the greater the chance of an uncontrolled selloff in the CNY, which would drag down the euro (Chart 14). Chart 13Is The Dollar Technically Vulnerable? Chart 14China Remains The Euro's Main Risk Despite this level of near-term uncertainty, we recommend investors buy the euro, with a target at 1.25, and a stop loss at 1.1175. Bottom Line: Conditions are falling in place for the countertrend decline in the euro to end soon. As a result, the euro should converge back toward the upward path driven by fundamentals. The greatest near-term risk remains the path of Chinese credit trends. We recommend investors buy the euro with a preliminary target at EUR1.25 and a stop loss at 1.1175.   Country Focus: A Well Discounted BoE Hike The Bank of England will begin to increase interest rates at its December meeting. The BoE’s communication has been clear that it does not see a need to wait between the end of its tapering program in December and the beginning of its hiking campaign. Recent comments by senior MPC members, including new Chief Economist Huw Pill, also suggest a rate hike is looming. Chart 15The BoE's Inflation Problem We see little reason to doubt the willingness of the MPC to start lifting the Bank Rate. UK Core CPI stands at 3.1% or 110 basis points above the BoE’s inflation target. Moreover, both market-based and survey-based long-term inflation expectations are well above 3.5%, which increases the risk of a dangerous dis-anchoring of UK inflation (Chart 15). UK economic activity remains inflationary. Wages are strong, climbing 7.2% in August. This number probably exaggerates the underlying wage growth due to compositional effects, but job creation remains robust and the unemployment rate fell to 5.2%. The BoE was concerned that the end of the furlough scheme last month would cause a jump in unemployment, but their fears have dwindled, because job vacancies stand at a record high and capex intentions are solid (Chart 16). The housing market continues to be a tailwind to growth. House prices are up 10% annually, which lifts household net worth considerably (Chart 17). The pace of transactions in the real estate market will slow this spring because the stamp duty holiday will end; however, low mortgage rates and expectations of further housing gains may fuel greater appreciation. This creates long-term financial stability risks for the UK because household leverage will rise. This worries the BoE. Chart 16The UK's Labor Market Strength Will Continue Chart 17Rising Household Net Worth Market participants already expect a hawkish BoE. A rate hike is priced in for December and the SONIA curve embeds almost two more increases in 2022. The 4.3% underperformance of the UK government bond index over the global benchmark in seven weeks also underscores the rapid adjustment in investors’ perceptions of the UK policy path. BCA’s Global Fixed-Income strategists have underweighted UK government bonds for two months, and they maintain a negative view over the coming quarters.  Nonetheless, the risk of a short-lived countertrend rebound in UK bonds’ relative performance is significant. However, it would be a temporary position squaring, while hedge funds and CTAs take profits. BCA’s Foreign Exchange strategists expect GBP/USD to rebound. Cable is oversold and trades at a 12% discount to BCA’s PPP fair-value estimate. GBP/USD is also hurt by fears that the BoE hikes will damage the UK economy. From a contrarian perspective, this creates a positive entry point to buy cable, especially because the pound should benefit from the anticipated dollar weakness and the euro’s upcoming rally. However, BCA’s FX strategists also foresee some decline in the pound versus the euro, because GBP is a low beta play on EUR/USD. Hence, the trade-weighted pound could remain flat to slightly down in the coming months. We stay neutral on UK small-cap stocks relative to large-cap equities, but we are putting them on an upgrade alert. Small-cap stocks benefit from the strength in the domestic economy; however, they are also extremely expensive compared to large-cap ones (Chart 18). The arbiter of performance will be profits. The forward EPS of small-caps have lagged behind those of large-caps by 9% since the COVID recession, after underperforming since 2016 (Chart 19). Small-caps’ relative profits are currently trying to stabilize, but the durability of this trend will be tested if the trade-weighted pound remains flat in the coming months. Thus, the EPS of small-cap shares must regain more ground before moving more aggressively in this market. Chart 18UK Small Cap Are Pricey Chart 19Follow The Profits Bottom Line: On the back of a strong UK economy and significant inflationary forces, the BoE will start elevating interest rates this December. The market already prices in this outcome. Nonetheless, UK bonds should continue to underperform the global benchmark, and cable has upside, even if the near-term outlook favors the EUR over the GBP. We are putting UK small-cap stocks on a buy alert. They are expensive, but a turnaround in profits would solve this problem. Market Focus: A Quick Take On Italian Equities The Italian equity market remains Europe’s problem child. The Italian MSCI index has underperformed the rest of the Euro Area by 40% since 2010. This underperformance holds even after adjusting for sectoral differences, although it becomes less dramatic (Chart 20, top panel). Despite this underperformance, Italian equities have managed to outperform their Spanish counterparts by 27% since 2010, but this outperformance dissipates once sectoral difference are accounted for (Chart 20, bottom panel). The RoE of Italian non-financial listed equities is equivalent to the rest of the Eurozone, but it only reflects elevated financial leverage, as is the case in Spain (Chart 21). Italy’s RoA is poor, because Italy’s excess capital stocks hurts its return on capital. As a result, Italian equities continue to face a structural handicap. Chart 20A Problem Child Chart 21Italy's Return On Asset Is Poor The good run in Italian equities in absolute terms faces headwinds. Italian stocks are very sensitive to the global business cycle; however, they often respond with a delay and in an exaggerated fashion to decelerations in the global PMI (Chart 22, top panel). Moreover, since 2010, widening European high-yield corporate bond spreads have preceded falling Italian stock prices. Thus, the recent slide in the global PMI and the widening in European high-yield OAS create a period of vulnerability for Italian equities. Finally, Italian share prices have overshot the path implied by US yields (Chart 22, bottom panel). Nonetheless, Italian stocks may be sniffing out further increases in global yields. The cleanest way to play these vulnerabilities in the Italian is via a short bet against Spain. A steeper global yield curve will help both markets due to their heavy exposure to financials. However, we still favor Spanish financials, which benefit from higher RoEs than their Italian counterparts (Chart 23) and lower NPLs. As a result, the forward EPS of Spanish financials should begin to outperform those of Italian financials. Chart 22Some Risks To Italian Stocks Chart 23Spanish Banks Are Better Placed To Benefit From Rising Global Yields   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights UK GDP is on track to overtake pre-pandemic levels. This will strengthen the case for the BoE to tighten monetary policy. That said, markets are aggressively pricing in a hawkish BoE. This creates room for near-term disappointment. The post-Brexit environment still remains volatile, especially vis-à-vis Northern Ireland. This opens a window to tactically go long EUR/GBP. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.45 over the next 12 months. Feature Chart I-1A Robust Recovery In UK Growth The UK recovery has been progressing smartly (Chart I-1). GDP growth is on track to increase by 7.25% this year, and 6% next year, according to the Bank of England (BoE). This is well above potential, and will eclipse growth in other developed economies. Markets have reacted accordingly. The pound is marginally higher versus the dollar this year, despite broad-based USD strength. Gilt yields have risen versus most developed market long rates. The OIS curve is already discounting at least 3 rate hikes by the BoE next year, much higher than most other developed market central banks (Chart I-2). The risk is that it creates downside risks for sterling in the near-term, even if the longer-term outlook remains bullish. Chart I-2A Violent Repricing In Interest Rate Expectations Robust Domestic Conditions Most measures of domestic demand in the UK remain robust. The employment rate is higher than in the US, with unemployment fast approaching NAIRU (Chart I-3). Projections from the BoE no longer forecast an acute impact from the expiration of the furlough scheme. Unemployment should hit 4.25% in 2022, pinning it close to the lows of the last several decades. Chart I-3The UK Versus US Jobs Recovery An Employment Boom Robust labor market conditions are beginning to shift bargaining power to workers. Vacancy rates are closing in on fresh highs relative to unemployed workers and wages have inflected noticeably higher (Chart I-4). The BoE has noted that compositional effects could have exarcerbated the pace of wage increases, with most job losses aggregated in sectors with lower pay. As the economy progresses towards full employment, wage growth will moderate from current levels, but will still be very robust by historical standards. Inflation has been the wild card in the UK. The headline inflation print is currently 3.2%, while core CPI sits at 3.1%, well above the MPC’s 2% target. Meanwhile, the 10-year CPI swap rate has shot up to 4.2%, brewing expectations that higher inflation could become entrenched (Chart I-5). This has pushed up bets that the central bank could turn even more hawkish. Chart I-4Employees Are Gaining Bargaining Power Chart I-5Will UK Inflation Be Transitory? From a big picture perspective, the acute increase in money supply growth stemming from aggressive easing by the BoE has stimulated economic activity. As such, the velocity of money is rising sharply in the UK (Chart I-6). To prevent a potential overheating of the economy, the BoE will need to raise rates. This is bullish for cable. Finally, house price inflation in the UK remains robust. While this has been a global phenomenon, surveys suggest that the pace of house price increases will accelerate in the coming months (Chart I-7). With the most negative interest rates in the G10, this will be cause for concern for the BoE Chart I-6Money Velocity In The UK Chart I-7Will The Housing Boom Be Sustained? The Policy Response Chart I-8The BoE Will Withdraw Emergency Monetary Settings On the monetary policy front, the BoE is acting accordingly. Asset purchases are slated to end soon, with the central bank having bought £869bn of its £895bn target (Chart I-8). In fact, two members of the MPC voted at the last policy meeting to reduce this target by £35bn, which would have effectively ended QE. Meanwhile, markets are priced for at least three interest rate hikes over the next 12 months. We agree that tighter monetary policy is warranted over the longer term. However, our bias is that market expectations for interest rate increases may have overshot, a potential setup for disappointment in the very near term. Offsetting Factors Inflation in the UK could prove transitory, and fall much faster than the market expects. According to BoE forecasts, inflation should settle closer to 2% by the end of next year. Yet the market is still pricing in very sticky inflation in the UK. The 5-year inflation swap currently sits at 4.4%, while the 10-year sits at 4.2%. These are very high numbers which are susceptible to downside surprises in the coming months. A firm trade-weighted pound will be the first catalyst for lower inflation. Historically, a strong GBP has dampened inflationary pressures through lower input costs (Chart I-9). It is remarkable that there has been a strong divergence between the currency and inflation expectations in the current regime. This can be partly attributed to a pandemic-related surge in restaurant and hotel costs, high transportation costs, and a surge in housing utilities, all amidst an electricity shortage (Chart I-10). Global supply chains are also under siege. Chart I-9The Inflation Overshoot Will Not Persist Chart I-10Transport And Utility Inflation Could Prove Transitory However, energy costs in Europe could modestly subside in the coming months. The opening of the Nord Stream 2 pipeline, connecting Russia with Europe, will help alleviate the euro zone energy crisis. For the UK in particular, the opening of the 1,400 MW undersea cable with Norway this month should assuage the electricity shortage. The pace of house price appreciation may also temper going forward. The UK holiday stamp duty, introduced in July 2020, expired last month. Under the scheme, taxes paid on property purchases were exempt to a ceiling of initially £500,000 until March 2021, and eventually £250,000. Housing in the UK has been supported by low interest rates and higher savings, factors pushing up global real estate demand, but the pickup in housing transactions ahead of the expiry of the rebate should ebb.  The post-Brexit environment also remains volatile, especially vis-à-vis Northern Ireland. Significant checks exists on goods from the UK to Northern Ireland, even if they are slated for final consumption. This is leading to delays, and hampering UK businesses. The UK has been pushing back strongly against this, asking for an adjustment to the Brexit agreement. So far, the UK trade balance with the EU has been recovering, but overall, balance of payments dynamics remain a negative (Chart I-11). As we go to press, Europe’s Brexit negotiator, Maros Sefcovic, is being pressed by member states to draw up retaliatory measures, should the UK default on its agreement. Chart I-11The UK Trade Balance With The EU Is At Risk Finally, the pound is also being held hostage to global macro dynamics. The UK runs a basic balance deficit. This means portfolio inflows, both in equities and bonds are needed to finance the trade deficit. These portfolio flows accelerated this year, but are now relapsing (Chart I-12). The risk is that a correction in global equity markets could exarcebate this trend (Chart I-13). Chart I-12Portfolio Flows Into The UK Have ##br##Slowed Chart I-13The Pound Is Susceptible To A Market Correction   Trading Opportunities The pound is likely to fare well over a cyclical horizon. Our 12-month target is 1.45 with a best-case scenario above 1.50. This target is based on mean reversion towards fair value. On a real effective exchange rate basis, the pound is about 15% below the mean. This is lower than where it was after the UK exited the Exchange Rate Mechanism in 1992 (Chart I-14). Over time, the pound will converge towards the mid-point of this historical range, pushing it near 1.50. Our in-house PPP models suggest the pound is undervalued by 12%. Our models on average revert to the mean over three years, suggesting the pound could revert to fair value in the next 12-to-18 months (Chart I-15).1  Our intermediate-term timing model suggests the pound is 0.5 standard deviations below fair value, and will also gravitate towards 1.50 over the next year or two. This model incorporates risk variables such as corporate spreads and commodity prices that drive fluctuations in the pound (Chart I-16). Chart I-14The Trade-Weighted Pound Is Cheap Chart I-15GBP/USD Is Cheap On A PPP Basis Chart I-16GBP/USD Is Cheap On A Competitive Basis However, in the near term, the pound could relapse versus other G10 currencies. EUR/GBP: Interest rate expectations are bombed out in the euro area, relative to the UK. This is occurring at a time when PMI data remain relatively upbeat in the eurozone (though rolling over, Chart I-17). A modest reset in relative rate expectations could ignite EUR/GBP. We are initiating a long position at 0.846, with a stop loss at 0.835. GBP/JPY: The pound has rallied hard against the yen this year. Yet, real interest rates in the UK have cratered relative to Japan, as inflation has overshot in the former. The trade balance with Japan is also deteriorating, one year after a free-trade agreement was signed (Chart I-18). This divergence cannot last as relative trade surpluses/deficits have driven the exchange rate over the last three decades. We expect the yen to modestly outperform the pound in the next 3-to-6 months. AUD/GBP: The Aussie should outperform the pound. First, the cross has tremendously lagged levels implied by relative terms of trade. Even if commodity prices relapse, the margin of safety will remain very wide. Second, investors are massively short the Aussie relative to cable. From a contrarian perspective, this will pull AUD/GBP higher (Chart I-19). Chart I-17Buy EUR/GBP For A Trade Chart I-18GBP/JPY Is Vulnerable In The Short Term Chart I-19AUD/GBP Still Has Upside Overall, sentiment on the pound remains ebullient, and our intermediate-term technical indicator has yet to hit capitulation lows (Chart I-20). This is modestly negative in the short term. That said, should the dollar experience broad-based weakness, as we expect, the pound might underperform the crosses, but will fare well against the dollar. Chart I-20Cable Will Hit Capitulation Lows Soon   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Strategy Report, "Updating Our PPP Models," dated November 13, 2020. Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights As US inflation proves to be not-so-transitory, US interest rate expectations will rise. Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. The net impact from China’s slowdown and higher US interest rate expectations on mainstream EM will be currency depreciation. Rising mainstream EM nominal and real (inflation-adjusted) interest rates do not often lead to domestic currency appreciation A strengthening dollar vis-à-vis EM currencies is bad news for EM fixed-income markets – both local currency bonds and credit markets. Feature This report discusses EM local currency (domestic) bonds and US dollar bonds (credit markets). To begin with, we reiterate our main macro themes since January this year: (1) a slowdown in China and (2) rising US inflationary pressures and higher US bond yields. These macro themes will create tailwinds for the US dollar, at least for the next several months. A strengthening dollar is bad news for EM fixed-income markets. China’s Slowdown China’s slowdown will continue to unfold. China’s credit (TSF1 excluding equity) growth has slowed further in September (Chart 1, top panel). Similarly, household mortgages are also decelerating sharply (Chart 1, bottom panel). Chart 1China's Money And Credit Are Decelerating Chart 2Curtailed Financing For Property Developers = Less Construction Activity     China's ever-important property market and construction activity will contract in the months ahead. Property sales were down by 20% in September from a year ago. Property developers in recent years have been relying on pre-construction sales as a major source of financing. With pre-sales drying up and borrowing restrained by both government regulations and creditors’ unwillingness to lend, property developers will be unable to sustain the current pace of construction and completion (Chart 2). Chart 3Red Flags For EM ex-TMT Stocks For the same reason, property developers have curtailed their purchases of land. Land sales have been a major source of local government revenues – it is estimated to account for 45% of local government revenues including managed (off-balance sheet) funds. The upshot will be that local governments will be unable to ramp up their infrastructure spending to offset shrinking property construction. Altogether, these will have negative implications for the mainland’s industrial economy and raw materials. Notably, global material stocks have rolled over decisively even though CRB Raw Materials price index has yet to peak (Chart 3, top panel). Global industrial stocks in general and machinery stocks in particular have also relapsed. Finally, Chinese non-TMT share prices have dropped by 20% from their February high and EM ex-TMT equity prices have formed a head-and-shoulder pattern, which often precedes a major gap down (Chart 3, bottom panel). These equity market signals are foreshadowing a slowdown in China’s “old economy”. Bottom Line: The shockwaves emanating from the slowdown in China will hinder growth in Asia and commodity-producing economies in the rest of EM. This is positive for the US dollar because among major economic blocks, the US economy is the least exposed to the mainland economy. US Interest Rates Will Be Repriced US bond yields will continue marching higher, supporting the US dollar. The reasons for higher bond yields are as follows: Investors and commentators can differ on their assessment of the US inflation outlook. However, one thing that we should all agree on is that uncertainty over the US inflation outlook is extraordinarily high. Heightened uncertainty requires a higher risk premium in bonds, i.e., a wider bond term premium. Surprisingly, until August, the term premium on US bonds was very subdued (Chart 4). In brief, the US bond term premium will rise to reflect uncertainty around the inflation outlook, which will push bond yields higher. US wages hold the key to the inflation outlook. We believe that wage growth will surprise to the upside as many companies have strong order books but are struggling to hire. As people gradually return to the labor force, employers have a once in a decade chance to attract qualified employees. Hence, companies will likely compete with one another by offering higher wages to attract the most qualified candidates. The job quit rate is the highest it has been since the early 2000s. This rate also points to higher wages (Chart 5). Chart 4High Inflation Uncertainty Heralds Higher Bond Term Premium And Yields Chart 5US Wage Growth Will Accelerate   Three factors that had suppressed US bond yields will likely be reversing: US commercial banks have been major buyers of US Treasurys and agency securities; the US Treasury has depleted its account at the Fed due to the debt ceiling but will now begin issuing more bonds to fill in this account; the Fed has been purchasing $80 billion of US government bonds each month; however, the Fed is preparing to taper and therefore reduce these purchases. Chart 6US Banks Have Been Buying Bonds En Masse US commercial banks’ holdings of US government and agency securities has risen to 19% of their total assets – on par with their early 1990s all-time high (Chart 6, top panel). In turn, the share of loans and leases has fallen to an all-time low (Chart 6, middle panel). As US banks begin to expand their lending, they will likely reduce the pace of their buying of US Treasurys. This along with the US Treasury issuing more paper to increase its depleted Treasury General Account at the Fed (Chart 6, bottom panel) and the Fed’s tapering will likely push up US bond yields. Current shortages are the result of excessive demand, rather than producers operating below capacity.2 The fact is that the supply/shipment of goods is booming, at least from Asia/China to the US. This will prove to be inflationary, and therefore lead to higher bond yields. Chinese shipments to the US continue to thrive – in September, export values were up by 30.5% from a year ago (Chart 7, top panel). Given that US import prices from China are rising at an annual rate of 3.8%, China’s export volume to the US has grown to about 26.7% from last September when it was already booming. Consistently, inbound containers unloaded at the Long Beach and LA ports have surged to all-time highs (Chart 7, bottom panel). Hence, US ports are not operating below capacity, it is excessive demand for goods that has created these bottlenecks. Finally, concerning semiconductors, shortages are due to excessive demand not a failure to produce. Global semiconductor production has been growing rapidly over the past two years. A silver lining is that a capitalistic system will eventually expand production and meet demand. Although we broadly agree with this expectation, it will take a couple of years for this to take place. In the interim, we can expect to see higher prices, at least for goods, and rising inflation expectations. Bottom Line: As US inflation proves to be not-so-transitory, US interest rate expectations will rise, which will support the US dollar. The broad-trade weighted US dollar has been correlated with US TIPS yields (Chart 8). Chart 7Shipments From Asia To The US Have Been Booming Chart 8High US Rates Will Support The Dollar   EM Domestic Bonds Chart 9EM Inflation Has Been Spiking EM domestic bond yields have been rising as inflation in EM ex-China, Korea, Taiwan (herein referred as mainstream EM) has been surging (Chart 9). Even if commodity prices roll over, EM interest rate expectations will likely continue rising for now because of higher US bond yields and EM currency weakness. Many clients have been asking whether rising mainstream EM policy rates and local bond yields will support EM currencies. We do not think so. In high-yielding interest rate markets such as Brazil, Mexico, South Africa, Russia and Turkey, neither short- nor long-term rates have been positively correlated with the value of their currencies (Chart 10 and 11). Chart 10Higher Bond Yields Do Not Lead To Currency Appreciation In Brazil And Mexico Chart 11Higher Bond Yields Do Not Lead To Currency Appreciation In Russia And South Africa Chart 12Higher EM Inflation-Adjusted Bond Yields Do Not Lead To EM Currency Appreciation Further, in these markets real (inflation-adjusted) rates also have not been positively correlated with their currencies (Chart 12). As illustrated in Charts 11, 12 and 13, there has been no positive correlation between both EM nominal and real (inflation-adjusted) interest rates and their currencies. Rather, there has often been a negative correlation. The basis is that exchange rates drive interest rate expectations, not vice versa. Currency depreciation leads to higher inflation expectations and rising interest rates. Conversely, exchange rate appreciation dampens inflation expectations paving the way for declining interest rates. Bottom Line: The net impact China’s slowdown and higher US interest rate expectations on mainstream EM domestic bonds will be currency depreciation with little room for their central banks to cut rates. As a result, local bonds’ risk-reward factor remains an unattractive tradeoff. EM Credit Markets As we laid out in A Primer on EM USD Bonds report  on April 29, EM exchange rates and their business cycle are the key drivers of EM sovereign and corporate credit spreads. If EM currencies drop, EM sovereign and corporate credit spreads will widen (Chart 13). The basis is that foreign currency debt servicing will become more expensive as EM currencies depreciate. As EM growth disappoints, EM credit spreads will widen too (Chart 14). Chart 13EM Credit Spreads And EM Currencies Chart 14EM Profit Expectations And EM Corporate Spreads   In addition, the continuous carnage in Chinese offshore corporate bonds will heighten odds of a material selloff in this EM credit. Chinese property companies’ USD bonds make up a more than half of China’s offshore USD corporate bond index and a large part of the EM corporate bond index. Poor performance of the EM corporate bond index could trigger outflows from this asset class. Investment Recommendations Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. As the interest rate differential between China and the US narrows, the CNY will likely experience a modest setback versus the greenback (Chart 15). Even small RMB weakness could produce a non-trivial depreciation in EM exchange rates. The latter is negative for EM local currency bonds and EM credit markets. Absolute-return investors should stay on the sidelines of EM domestic bonds. For dedicated investors in this asset class, our recommended overweights are Mexico, Russia, Korea, India, China, Korea, Malaysia and Chile. EM credit markets will continue to underperform their US counterparts (Chart 16). Credit investors should continue underweighting EM credit versus their US counterparts, a strategy we have been recommending since March 25, 2021. Chart 15CNY/USD And The Interest Rate Differential Chart 16EM Credit Markets Are Underperforming Their US Peers   Finally, EM ex-TMT share prices correlate with inverted EM USD corporate bond yields (Chart 17). Higher EM corporate bond yields (shown inverted in Chart 17) entail lower EM ex-TMT share prices. Chart 17High EM USD Bond Yields Herald Lower Share Prices In turn, China’s TMT stocks remain vulnerable as we have argued in past reports. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Total Social Financing. 2 We made a similar case for Chinese electricity shortages in last week’s report. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations