Currencies

Highlights The odds of a Goldilocks outcome for the US economy increased somewhat in August, but the risks of a US recession over the coming year remain quite elevated. We continue to recommend that investors stay neutrally positioned towards equities within a global multi-asset portfolio. The disinflationary impulse from the July US CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices. It is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. The OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, but it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023. This suggests that a further upward adjustment in the OIS curve is likely warranted, and that a modestly short duration stance is appropriate. Investors believe that the rate hike path priced into the OIS curve would not be recessionary, because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation. From the perspective of market participants, this would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. We agree that the odds of a recession will decline if headline inflation does fall below 4% over the coming year, but it is not yet clear that this will occur. And if it does, the resulting improvement in real wages would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put heavy pressure on equity multiples. This underscores that stock prices face risks in both a recessionary and non-recessionary environment. There are arguments pointing to a decline in the dollar beyond the near term, even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. Stay neutral for now, but look for opportunities to short the dollar beyond the coming few months. Jumping The Gun On Goldilocks The odds of a Goldilocks outcome for the US economy over the coming six to nine months increased somewhat in August. The July CPI report presented some evidence of supply-side and pandemic-related disinflation (Chart I-1), and we saw more resilient manufacturing production in the US – even after excluding the automotive sector – than many manufacturing indicators have been indicating (Chart I-2). In addition, the regional Fed manufacturing index in the especially manufacturing-sensitive state of Pennsylvania surprised significantly to the upside in July, although this was at least somewhat offset by a collapse in the New York and Dallas Fed’s general business conditions indexes (Chart I-3). Chart I-1There Is Now Some Evidence Of Supply-Side & Pandemic-Related Disinflation In The US Chart I-2US Manufacturing Production Has Been More Resilient Than Surveys Would Have Suggested Against the backdrop of significant recessionary risks, and a debate about whether negative growth in the first half of the year already constitutes a recession in the US, these developments have been positive. The Atlanta Fed’s GDPNow model is pointing to positive (albeit below-trend) growth of 1.4% in Q3, which is consistent with consensus forecasts. The Atlanta Fed’s model is also forecasting the strongest real consumption growth since Q4 2021 (Chart I-4). Equity investors responded to incrementally lower recession odds and a slower pace of inflation by bidding up the S&P 500 from roughly 3800 at the beginning of July to over 4200 in August. Chart I-3Mixed Messages From The Regional Fed Indicators Chart I-4The Atlanta Fed GDPNow Model Is Pointing To Positive Growth And Resilient Consumption In Q3   However, several other developments over the past month continue to highlight that the risks of a US recession over the coming year are quite elevated, which supports our recommendation that investors stay neutrally positioned towards equities within a global multi-asset portfolio: The August flash PMIs were fairly negative, especially for the services sector. The August flash S&P Global manufacturing PMI rose in Germany, but it fell in the US, France, and the UK. Services PMIs declined significantly in all four countries, especially in the US where survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed.” Survey respondents also noted that “new orders contracted at the steepest pace for over two years, as companies highlighted greater client hesitancy in placing new work.” Chart I-5The Conference Board's LEI Is Very Weak The Conference Board’s leading economic indicator dropped for a fifth month in a row in July, which has always been associated with a US recession (based on the indicator’s current construction). Chart I-5 highlights that the indicator’s market-based and real economy components are both very weak, and that the Conference Board’s coincident indicator has now fallen below its 12-month moving average. While the Philly Fed manufacturing index picked up in July, the new orders component of the regional Fed manufacturing PMIs broadly sank further into contractionary territory (Chart I-6). Chart I-6The Regional Fed New Orders Components Are Very Weak The Atlanta Fed model shown in Chart I-4 is pointing to a second quarter of negative growth from real residential investment, a component of GDP that reliably peaks in advance of economic contractions.1 Job openings are now pointing to a potential rise in unemployment. The relationship between job openings and unemployment is currently subject to heavy debate, as discussed in a recent report by my colleague Ryan Swift.2 However, abstracting from a theoretical discussion about movements along or shifts in the Beveridge curve, investors should note that the empirical record is fairly clear – Chart I-7 highlights that falling job vacancies occurred alongside a significant rise in the level of unemployment during the last two recessions. We acknowledge that the relationship has seen some deviations since 2018/2019, so this may highlight that a larger decline in job openings will be required for unemployment to trend higher. A 10% rise in the level of unemployment relative to its 12-month moving average has always been associated with a recession, implying that a sustained decline in job openings to 10M or lower would represent a likely recessionary signal – even if that recession proves to be a mild one (see Section 2 of this month’s report). Chart I-7Declining Job Openings Are Pointing To Potentially Higher Unemployment Table I-1 highlights that the disinflationary impulse from the July CPI report is less compelling than it seems, in that it appears to have been mostly driven by declining energy prices (particularly gasoline and fuel oil). Outside of the clear impact that falling fuel prices had on airline fares, there is not yet compelling evidence that core inflation is decelerating due to easing supply-side and pandemic-related effects, or due to slowing demand. As we will discuss below, it is far from clear that energy prices will continue to decline over the coming months and are, in fact, likely to rise even if an Iranian deal takes place. This implies that investors may have jumped the gun in pricing in substantial disinflation and sharply higher odds of a Goldilocks economic outcome. Table I-1The Disinflationary Impulse From The July CPI Report Is Less Compelling Than It Seems Inflation And The Fed As we discuss in Section 2 of our report, recessions occur because monetary policy becomes tight, a significant non-policy shock to aggregate demand or supply occurs, or some combination of both develops. We do not believe that monetary policy is currently restrictive on its own (Chart I-8), and we have not yet concluded that a US recession is inevitable. But when combined with the speed of adjustment in interest rates, the fact that real wages have fallen sharply (Chart I-9), and the fact that the Fed is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. Chart I-8Absent Declining Real Wages, The Current Level Of Interest Rates Would Not Be Restrictive Chart I-9But Real Wages Are Declining, And The Pace Of Tightening Has Been Extraordinarily Rapid Many investors do not appear to fully appreciate the fact that the Fed will continue to tighten policy until it sees clear and unequivocal signs that inflation is easing. Importantly, the minutes of the July FOMC meeting highlighted that this is likely to be true even if unambiguous signs of easing supply-side and pandemic-related inflation present themselves. During the July meeting, FOMC participants noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. They also emphasized that “a slowing in aggregate demand would play an important role in reducing inflation pressures”. The upshot is that the Fed was aware before the July CPI report that energy-related inflation might fall, but also understood that they would still have to tighten enough to slow aggregate demand to reduce underlying inflationary pressures. It is true that investors are pricing in additional rate hikes from the Fed, but there are two caveats for investors to consider. The first is that while the OIS curve is implying a reasonable path for the Fed funds rate for the remainder of this year, it is too low 12 months from now based on the Fed’s median rate expectation for year-end 2023 (Chart I-10). This suggests that a further upward adjustment in the OIS curve is likely warranted. Second, and more importantly, investors appear to be making the assumption that the rate hikes already built into the OIS curve will not be recessionary. Investors are making this assumption because short-term inflation expectations are pricing in a very substantial slowdown in headline inflation (Chart I-11), which would both raise the recessionary threshold for interest rates (via stronger real wages) and could potentially allow the Fed to reduce interest rates closer to its (very likely wrong) estimate of neutral. Chart I-10A Further Upward Adjustment In The OIS Curve Is Likely Warranted Chart I-11Short-Term Inflation Expectations Are Pricing In A Massive Deceleration In Headline Inflation We agree with investors that the odds of a recession will decline significantly, ceteris paribus, if headline inflation does drop below 4% over the coming year. But we noted above that it is not yet clear that this will occur. In addition, we disagree with investors that this would result in a reduction in short-term interest rates, because this belief is based on the view that monetary policy is currently in restrictive territory even without the negative impact of sharply lower real wages. Absent the negative real wage effect, our view is that monetary policy would still be stimulative at current interest rates, which is why we believe that the 2023 portion of the OIS curve is too dovish in a non-recessionary scenario. The Outlook for Stocks The equity market rally that began in early July has been based on the assumption that significant supply-side and pandemic-related disinflation is now a fait accompli. If it is, then the odds of a recession over the coming year are indeed meaningfully lower, and the risk to corporate profits is less than feared. We noted above that investors may have jumped the gun in pricing in substantial disinflation and sharply lower odds of a US recession. But even in a scenario in which the odds of recession do come in significantly, stocks still face risks from a significant rise in real bond yields. Chart I-12Long-Maturity TIPS Yields Would Likely Rise In A Non-Recessionary Scenario, Compressing Equity Multiples Investors have been focused on very elevated inflation as the driver of both rising inflation expectations and rising real bond yields, and have assumed that a meaningful slowdown in inflation (as forecast by short-term measures of inflation expectations) implies that the Fed funds rate will return to the Fed’s estimate of neutral. This belief, along with a lower projected Fed funds rate in 2024 than 2023 in the FOMC’s participant forecasts, is the basis for the 2023 “pivot” currently priced into the OIS curve. Given that the Fed funds rate has already reached the Fed’s neutral rate estimate, there is a meaningful chance that this estimate will be revised upwards by the Fed or challenged by investors if economic activity improves in response to a decline in inflation and a corresponding rise in real wages. Such a scenario would highlight to investors that the Fed’s estimate of neutral is likely too low, which would imply a significant increase in real 10-year TIPS yields (which are currently 160 basis points below their pre-2008 average). Chart I-12 highlights the impact that a rise in real long-maturity bond yields could have on equities, even in a non-recessionary scenario where 12-month forward earnings per share grows 8% over the coming year. A rise in 10-year TIPS yields to 1.5% by the middle of 2023 would cause a 16% contraction in the 12-month forward P/E ratio and a 10% decline in stock prices, assuming an unchanged 12-month forward equity risk premium (ERP). It is possible that the ERP could decline in a rising bond yield scenario. Chart I-13 highlights that the ERP is indeed negatively correlated with real bond yields (in part due to the methods that we use to calculate it). The counterpoint is that there are a number of risks that equity investors should be compensated for today that did not exist in the late 1990s or early 2000s, especially the risks of populist policies in many advanced economies and major geopolitical events (as Russia’s invasion of Ukraine recently highlighted). Chart I-14 illustrates that, since 1960, a long-term version of the equity risk premium, calculated using trailing earnings and our adaptive expectations proxy to deflate long-maturity bond yields, has been fairly well explained by the Misery Index (the sum of the unemployment and headline inflation rates). However, the chart also shows that the ERP has been structurally higher over the past decade than the Misery Index would have predicted. It is unclear if this is due to a riskier environment or the negative ERP/real yield correlation that we noted. Chart I-13The Equity Risk Premium Could Come Down As Bond Yields Rise, But That Is Not Guaranteed Chart I-14A Structurally Higher ERP Over The Past Decade Could Represent Needed Compensation For Structural Risks The conclusion is that investors do not yet appear to have a basis to bet on a declining ERP in a rising bond yield environment, underscoring that even a non-recessionary scenario poses a risk to stock prices. It is worth noting that this second risk facing stocks has essentially been caused by the Fed because of its maintenance of a very low neutral rate estimate that we feel is no longer economically justified. Bond Market Prospects Chart I-15Investors Should Stay Modestly Short Duration, For Now Over the past few months, the Bank Credit Analyst service has continued to recommend that investors maintain a modestly short duration stance even as we recommended reducing equity exposure. The recent rise in the 10-year Treasury yield back to 3% has validated that view (Chart I-15), and reinforces our view that there is significant upside risk to long-maturity bond yields in a non-recessionary scenario. Our expectation that the Fed will raise interest rates to a higher level over the next year than the OIS curve is currently discounting also argues for a modestly short stance, based on BCA’s “Golden Rule” framework. The “Golden Rule” states that investors should set their overall bond portfolio duration based on how their own 12-month fed funds rate expectations differ from the expectations that are priced into the market. As we detail in Section 2 of our report, the Fed has always cut interest rates in response to a recession in the post-WWII environment, so we would certainly recommend a long duration stance if a recession emerges. But given our view that a recession is still a risk rather than a likely event, we feel that a modestly short duration stance is currently appropriate. Chart I-16US Corporate Bond Value Has Improved, But Not Enough To Trump The Cycle As noted above in our discussion of the risks facing stock prices in a non-recessionary scenario, falling inflation that is not associated with a recession will ironically be a bearish signal for long-maturity bonds, because it means that the Fed will have greater capacity to raise interest rates without ending the recovery. The short end of the yield curve could be flat or move modestly lower in response to a significant easing in inflation, but the long end of the curve would be at serious risk of moving higher. We are thus very likely to recommend a short duration stance in response to solid evidence of true supply-side and pandemic-related disinflation, assuming it emerges outside of the context of a recession. Within the credit space, the rise in US corporate bond spreads since the start of the year has meaningfully improved the value of investment- and speculative-grade corporate bonds (Chart I-16), but not so much that it justifies a positive stance towards these assets relative to government bonds given the risks facing the US economy. We continue to recommend an underweight stance towards investment-grade and a neutral stance towards speculative-grade within a fixed-income portfolio. The Outlook For Energy Prices Chart I-17The EU's Oil Embargo Will Cause Russian Oil Production To Tank The likely path of commodity prices, particularly that of oil, is an extremely important determinant of whether the US is likely to experience a recession over the coming year. We are among those who have downplayed the significance of oil price shocks in driving contractions in economic output over the past two decades,3 but the current situation is unique given the role that very elevated inflation has played in driving real wages lower. In a recent Strategy Report from our Commodity & Energy Strategy service, my colleague Robert P. Ryan underscored the impact that the European Union’s embargo of Russian oil will likely have on the energy market. If fully implemented, ~ 2.3mm barrels/day of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. EU, UK and US shipping insurance and reinsurance sanctions are also scheduled to be implemented in December, which means that “surplus” Russian oil production cannot be fully reoriented to other countries. Chart I-17 presents the likely impact on Russia’s crude oil output, namely a ~ 2mm barrels/day decline in oil output by the end of next year – nearly equal to the amount of oil set to be embargoed. Our base case view remains that supply and demand in the oil market will remain relatively balanced going into the winter, but the removal from the market of Russian oil production because of the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will ultimately push crude oil prices higher and inventories lower (Chart I-18). The price impact of this event could happen earlier than the immediate supply/demand balance would suggest, if investors have not fully priced in the extent of the decline in Russian oil production that our commodity team is forecasting. Our commodity team’s forecast serves as an important reminder that the economic consequences of Russia’s invasion of Ukraine may not be fully behind us. It also highlights that the recent disinflation observed in the US, which was mostly driven by lower energy prices in July, may not be sustained. Chart I-19 highlights what could happen to US gasoline prices based on the path for oil shown in Chart I-18, and how that forecast is sharply at odds with the current gasoline futures curve. Chart I-20 highlights that US gasoline stocks are currently below their 5-year average; the last time this occurred was in Q1 2021, which was an environment of rising gasoline prices to levels that were higher than what would usually be implied by crude oil prices. Chart I-18Oil Prices Are More Likely To Rise Than Fall Chart I-19Higher Oil Prices Would Cause Gasoline Prices To Deviate Significantly From Market Expectations Chart I-20Gasoline Stocks Are Low In The US, Underscoring The Upside Risk To Prices The upshot is that our commodity team expects oil prices to move higher over the coming 6-12 months, under the assumption that the EU’s embargo against Russian oil moves forward as announced. This poses a clear threat to imminent supply-side and pandemic-related disinflation, and underscores the risks to a Goldilocks economic outcome over the coming few months. The Dollar: Value, Technical Conditions, And The Cycle Chart I-21The Dollar Is Reliably Countercyclical, But It Has Registered Outsized Gains Over The Past Year The US dollar moved higher over the past month, after first retreating from its mid-July high for the year. We tempered our view about the likelihood of a falling dollar over the near term in last month’s report, but from a bigger picture perspective we have been surprised by the degree of dollar strength this year. The US dollar is a reliably countercyclical currency, so clearly some of the dollar’s strength has been the result of weakness in risky asset prices (Chart I-21). But the bottom panel of Chart I-21 highlights that the broad trade-weighted dollar has performed even better over the past year than returns to the S&P 500 would have implied, underscoring that the magnitude of the dollar’s strength has been atypical. The last two times that the US dollar performed substantially better than the trend in risky assets would have implied were in 2012 and 2015, years in which euro area breakup risk was a driving force in markets. Alongside the fact that EURUSD has fallen below parity and USDEUR has outperformed even more than the broad trade-weighted dollar has, “excess” dollar returns point strongly to Europe’s energy woes in the aftermath of Russia’s invasion of Ukraine as the key driver of outsized broad dollar strength. Chart I-22 highlights that European natural gas prices have exceeded the level that we had forecasted would occur in a complete cutoff scenario, meaning that Europe’s energy crunch is likely happening now, rather than in the winter. However, even considering the negative economic outlook facing the euro area, there are arguments pointing to a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. First, Chart I-23 highlights that EURUSD has undershot what the trend in relative real interest rates would suggest, which has historically led changes in the euro. This implies that the euro has declined partly because of the introduction of a sizeable risk premium, which may dissipate after the winter. Chart I-22The Euro Has Been Heavily Impacted By Europe's Energy Crunch Chart I-23EURUSD Has Undershot What The Trend In Relative Real Interest Rates Would Suggest Second, Chart I-24 highlights that the US dollar is extremely overbought and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. Finally, Chart I-25 highlights that the US dollar is extraordinarily expensive based on our valuation models, underscoring that an eventual decline in the dollar may be quite severe. We agree that valuation is not usually an effective market timing tool, but investors should place a greater weight on valuation measures as they are stretched further. Based either on our models or a more traditional PPP approach, the degree of US dollar overvaluation is extreme – arguing for a bearish bias on a 6-12 month timeline barring an unambiguous move towards recession in the US. Chart I-24US Dollar And Indicator The US Dollar Is Heavily Overbought Chart I-25The US Dollar Is Extremely Expensive         Investment Conclusions Considering the economic developments over the past month and the reaction of financial markets, the takeaway for investors seems clear. Market participants have eagerly shifted towards the Goldilocks economic and financial market outcome, based on (so far) incomplete evidence of supply-side and pandemic-related disinflation that has predominantly been driven by declining energy prices. Given significant potential upside risks to oil and US gasoline prices over the coming few months, investors should wait for more durable signs of significant disinflation before downgrading the odds of a US recession over the coming year. We would certainly recommend cutting global equity exposure to underweight were we to determine that the US is likely to experience an imminent recession, but the avoidance of a recession does not necessarily suggest that an overweight stance is warranted. Sharply lower inflation would reduce the odds of a recession, but it would also raise real wages and would ultimately allow the Fed to raise interest rates to a higher level before short-circuiting the economic expansion. As such, we expect real long-maturity government bond yields to rise meaningfully in a scenario where real wages recover significantly and a recession is avoided, which will put meaningful pressure on equity multiples. Barring a decline in the equity risk premium, US stocks could face a loss on the order of 10% over the coming year in such a scenario (even under the assumption of positive earnings growth), reinforcing our view that a neutral stance towards global equities is currently appropriate. In addition to a neutral global asset allocation stance, we recommend that investors maintain a neutral regional equity position and a neutral stance towards cyclicals versus defensives, although we do recommend a modest overweight towards value stocks given our view that a modestly short duration stance is appropriate. Although we recommend a neutral stance towards USD over the next few months, we also see ample scope for a decline in the dollar beyond the near term – even within the context of elevated recessionary odds in the US and our recommended neutral stance towards global equities. We believe that there are upside risks to energy prices, which our Commodity & Energy Strategy service recommends playing via the iShares GSCI Commodity Dynamic Roll Strategy (COMT) ETF. As a final point, we remain cognizant of the fact that financial markets rarely trend sideways over 6-to-12 month periods. We continue to regard a neutral global asset allocation stance as a temporary stepping stone either to a further downgrade of risky assets to underweight, or to an increase in risky asset exposure back to a high-conviction overweight. The latter is still possible, especially if we see unequivocal signs of a substantial and broad-based slowdown in the US headline inflation rate, and if long-maturity real bond yields are well-behaved in response or if we see clear signs of a declining equity risk premium. Thus, investors should note that additional changes to our recommended cyclical allocation may occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 25, 2022 Next Report: September 29, 2022 II. The Fed Funds Rate, Bond Yields, And The Next US Recession The risk of a US recession has increased sharply over the past several months. We have not yet concluded that a recession over the coming year is inevitable, but substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. The increased risk of a contraction has caused investors to ponder what the next recession might look like. One very important question concerns the likely behavior of short-term interest rates during the next recession, especially if it occurs sooner rather than later. The historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition, there are several arguments pointing to the next US recession being a mild one. For fixed-income investors, the implication is that investors should not overstay their welcome in a long-duration position during the next US recession, and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. Over the past several months, investors have been faced with a sharp increase in the odds of a US recession. Gauging the risk of a recession has featured prominently in our recent reports, and we have concluded, for now, that a US recession over the coming year is not yet inevitable. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Economic expansions do not last forever. This means that the US economy will eventually succumb to a recession at some point over the coming few years. One very important question for investors concerns the likely behavior of short-term interest rates during the next recession, especially if a contraction occurs sooner rather than later. A key aspect of this question is whether the Fed is likely to be forced back towards a zero or negative interest rate policy, and whether it will need to employ asset purchases as part of its stabilization efforts as it has during the last two recessions. If so, long-maturity bond yields are likely to fall significantly during the next recession; if not, investors may be surprised by how modestly long-maturity yields decline. In this report, we examine the historical record of short-term interest rates during recessions and discuss whether the next US recession is likely to be severe or mild. We conclude that the next US recession is more likely to be mild than severe, and that the 10-year Treasury yield is unlikely to fall below 2% during the recession (or fall below this level for very long). In the case of a more severe recession driven by unanchored inflation expectations, the implications would be clearly bearish for bonds. Within a fixed-income portfolio, one conclusion of our analysis is that investors should not overstay their welcome in a long-duration position during the next recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. The Historical Recessionary Path Of Short-Term Interest Rates When projecting how the Fed funds rate is likely to evolve during the next US recession, most investors typically look to the average decline in short-term interest rates during previous recessions as a guide. Based on that approach, Table II-1 highlights that the Fed would likely have to cut rates into negative territory if a recession occurred over the coming 12-18 months, unless it is able to hike interest rates significantly more over the coming year than the market is currently expecting and the FOMC itself is projecting. But in our view, focusing on the historical recessionary decline in interest rates from their peak is not the right approach, because it ignores the fact that recessions typically occur when monetary policy is tight. If a recession occurs within the next 18 months, it will have happened in large part because of a collapse in real wage growth, not just because of the increase in interest rates that has occurred. Chart II-1 highlights that short-term interest rates remain well below potential GDP growth, highlighting that monetary policy would still be easy today – despite the quick pace of increase in short rates – if real wages were growing rather than contracting sharply. In our view, the right approach is to examine how much short-term interest rates have typically fallen during recessions relative to potential or average historical GDP growth. This method captures the degree to which monetary policy easing has typically been required relative to neutral levels to catalyze an economic recovery. Table II-1Based Only On The Historical Decline In Short-Term Interest Rates, The Fed Would Ostensibly Have To Cut Rates Into Negative Territory During The Next Recession Chart II-1Monetary Policy Would Still Be Easy Today If Real Wage Growth Was Positive Based on this approach, Chart II-2 highlights that the Fed might have to cut the target range for the Fed funds rate to 0-0.25% during the next recession, but there are some examples (like the 1990-1991 recession) that point to a cut to just 0.25-0.5%. The goal of this exercise is not to be specific about the exact level to which the Fed will have to cut the Fed funds rate, but rather whether the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases is likely. Chart II-2The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory Structural bond bulls might note that there are five recessions in the post-war era that could potentially point to that outcome based on Chart II-2. However, these episodes involved circumstances that we doubt would be present during the next US recession, especially if one were to emerge over the coming 12-18 months. The 1950s Recessions The recessions of 1953-54 and 1957-58 were fairly sizeable based on the total rise in the unemployment rate, but the monetary policy stance at that time was wildly stimulative in a way that is very unlikely to repeat itself today. In the 1950s, the level of interest rates was still an artifact of WWII (with the Treasury-Fed accord having only been agreed upon in March 1951). Monetary policy was both overly responsive to a period of pent-up disinflation following the initial burst of government spending associated with the Korean war and insufficiently responsive to a strongly positive output gap (Chart II-3). This was meaningfully compounded by a poor understanding of the size of the output gap at that time; the deviation of the unemployment rate from its 10-year average was significantly smaller than its deviation from today’s estimate of NAIRU (Chart II-4). In sum, the economic and monetary policy conditions that existed in the 1950s and that contributed to an interest rate level that was well below the prevailing rate of economic growth do not exist today. As such, we strongly doubt that the Fed’s response to the next US recession would resemble what occurred during that decade. Chart II-3We Strongly Doubt The Fed's Response To The Next US Recession Would Resemble What Occurred In The 1950s Chart II-4Low Interest Rates In The 1950s Were Partly Caused By Wrong Output Gap Estimates   1973-1975 The recession that began in 1973 occurred because of a huge energy shock that proved to be stagflationary in the true sense of the word. Excluding the 2020 recession, this was the third largest rise in the unemployment rate of any recession since WWII, following 2008/2009 and the 1981/1982 recessions. There are some parallels between this recession and the current economic environment, but the stability of inflation expectations so far does not point to a truly stagflationary outcome. As such, we do not see the 1973-74 recession as a reasonable parallel to today’s environment. In addition, manufacturing employment – which was heavily impacted by the permanent rise in oil prices due to the sector’s energy intensity – stood at 24% of total nonfarm employment in 1973, compared with 8% today. Finally, the weight of food and energy as a share of total consumer spending today is roughly half of what it was during the 1970s (Chart II-5). 2001 Of the five recessions potentially implying that the Fed may have to cut interest rates into negative territory during the next US recession, the 2001 recession is the most relevant parallel to today. It was a modern recession in which the Fed maintained very easy monetary policy for a significant amount of time, in response to concerns about a significant tightening in financial conditions and the impact of prior corporate sector excesses on aggregate demand. The total rise in the unemployment rate during this recession was not very large, but it took some time for the unemployment rate to return to NAIRU. Still, even though this justified a later liftoff, a Taylor rule approach makes it clear that the Fed overstimulated the economy in response to the recession – a view that is reinforced by the enormous rise in household debt that fueled the housing market bubble during that period (Chart II-6). The Fed was very concerned about the negative wealth effects of the bursting of the equity market bubble, which had been caused by a massive decline in the equity risk premium in the second half of the 1990s. These conditions are simply not present today. Chart II-5Today's US Economy Is Meaningfully Less Impacted By Energy And Food Prices Chart II-6The Fed Clearly Overstimulated In Response To The 2001 Recession 2008/2009 Chart II-7A Repeat Of The 2008/2009 Recession In The US Is A Totally Implausible Scenario Chart II-2 highlighted that the Fed would have to cut interest rates to -1% were the 2008/2009 recession to repeat itself, but we judge that to be a totally implausible scenario given the improvement in US household sector balance sheets and financial sector health since the global financial crisis (Chart II-7). As we discuss below, the next US recession is likely to be meaningfully less severe than the 2008/2009 and 2020 recessions, which we believe carries important significance for the path of interest rates and the response of long-maturity bond yields. The bottom line for investors is that, based on the historical experience of rate cuts during recessions, the Fed may end up cutting interest rates back to or close to the zero lower bound in response to the next recession. But the de facto re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seems quite unlikely unless the recession is severe, which we do not expect. Will The Next US Recession Be Severe Or Mild? Chart II-8The Most Severe US Recessions Have Had Aggravating Factors That Do Not Appear To Be Present Today How drastically the Fed will be forced to cut interest rates during the next recession will be driven by its severity. Chart II-8 presents the total rise in the unemployment rate during post-WWII recessions (excluding 2020), in order to gauge whether the factors that have led to severe recessions in the past are likely to be present during the next contraction in output. From our perspective, the most severe US recessions in the post-WWII era have been driven by factors that are very unlikely to repeat themselves in the current environment. We noted above that a repeat of the 2008/2009 recession is a totally implausible scenario, leaving the 1981-1982, 1973-1975, and 1950s recessions as potential severe recession analogues. In three of these four cases we see clear signs of an aggravating factor that we do not (yet) believe will be present during the next US recession. Chart II-9Inflation Expectations Have Not Yet Unanchored To The Upside, In Sharp Contrast To The 1970s In the 1981-1982 recession, the unemployment rate rose significantly as the Federal Reserve confronted the fact that inflation expectations had become severely unanchored to the upside, causing a persistent wage/price spiral. While unanchored inflation expectations is a risk today, so far the evidence suggests that both households and market participants expect that currently elevated inflation will not persist over the long run (Chart II-9). If inflation expectations do become unanchored to the upside at some point over the coming 12-18 months (or beyond), we are very likely to change our view about the severity of the next recession. However, this would be a bond bearish outcome (at least initially), as it would imply sharply higher yields at both the short and long end of the yield curve in order to tame inflation and re-anchor inflation expectations. As noted above, in the 1973-74 recession, the unexpected and permanent rise in oil prices and outright energy shortages rendered a significant amount of capital and labor uneconomic, which is different than what has been occurring during the pandemic. Were the recent rise in natural gas prices to be permanent and no alternatives available, Europe’s current energy situation would be more reminiscent of the 1973-1974 recession than the pandemic-driven price pressures and supply shortages affecting the US and other developed economies. Chart II-10The US Is Currently Experiencing Fiscal Drag, But That Will Lessen Next Year Finally, while the 1957-58 recession appears to be somewhat of an anomaly driven by a mix of factors, the 1953-54 recession was clearly exacerbated by a sharp slowdown in government spending following the end of the Korean war. It is true that the US is currently experiencing fiscal drag (Chart II-10), but this has occurred against the backdrop of a strong labor market, and IMF forecasts imply that the drag will be significantly smaller over the coming year than what the US is currently experiencing. There are several additional points suggesting that the next US recession will be comparatively mild: Chart II-11The Milder US Recessions Were All Seemingly Triggered By Tight Monetary Policy (As Would Be The Case Today) Chart II-11 highlights that the milder recessions, those which have seen the unemployment rate rise by less than 3% from their previous low, have generally been the recessions that appear to have simply been triggered by monetary policy becoming tight or nearly tight. This would likely be the case during the next US recession. In the lead up to the 1970, 1990-91, and 2001 recessions, short-term interest rates approached or exceeded either potential growth or the rolling 10-year average growth rate of nominal GDP. The 1960-61 recession stands out slightly as an exception to this rule, in that interest rates were still moderately easy, which is based on our definition of the equilibrium short-term interest rate. But interest rates had risen close to 400 basis points from 1958 to 1960 (suggesting a change in addition to a level effect of interest rates on aggregate demand), and it is notable that the 60-61 recession was the mildest in post-war history, based on the total rise in the unemployment rate. Chart II-12Labor Scarcity May Mean That Firms Will Be Somewhat More Reluctant To Shed Labor During The Next Recession We argued in Section 1 of our report that monetary policy is not currently restrictive on its own, and that the recessionary risk currently facing the US is the result of a combination of the speed of adjustment in interest rates, the fact that real wages have fallen sharply, and the fact that the Fed is determined to see inflation quickly return to target levels. However, what this also highlights is that a recession would likely cause a rise in real wages via a significant slowdown in inflation (at least for a time); this would likely help stabilize aggregate demand and cause a comparatively mild rise in the unemployment rate. While the odds and magnitude of this effect are difficult to quantify, the fact that the labor market has been so tight over the past year and that the participation rate has yet to recover to its pre-pandemic levels suggests that some firms may be reluctant to shed labor during a recession (Chart II-12), suggesting that the total rise in unemployment in the next recession could be relatively small. Finally, Chart II-13 shows that the excess savings that have accumulated over the course of the pandemic, now primarily the result of reduced spending on services, dwarf the magnitude of precautionary savings that were generated in the prior three recessions as a % of GDP. We agree that the savings rate would likely still rise during the next recession, but the existence of excess savings implies that the rise in the savings rate may be surprisingly small – which would, in turn, imply a comparatively mild rise in the unemployment rate. We noted above that the household sector has deleveraged significantly, which is strong evidence against an outsized or long-lasting decline in consumer spending as a possible driver of an above-average rise in the unemployment rate during the next recession. One question that we often receive from clients is whether excessive corporate sector leverage could cause a more severe decline in economic activity once a recession emerges. Chart II-14 illustrates that the answer is “probably not.” The chart presents one estimate of the US nonfinancial corporate sector debt service ratio, based on national accounts data. The chart highlights that the current debt burden for the nonfinancial corporate sector is very low, underscoring that elevated corporate sector debt would not likely act as an aggravating factor driving an outsized rise in the unemployment rate were a recession to occur today. The chart also shows that even if the 10-year Treasury yield were to rise to 4% and corporate bond spreads were to widen in the lead up to a recession, the nonfinancial corporate sector debt service burden would rise to a lower peak than seen in the last three recessions. One key risk to a mild recession view is a scenario in which inflation does not return to or below the Fed’s target during the recession. In that kind of environment, the Fed would not likely cut interest rates to as low a level as they have in the past relative to potential growth. But the historical record is clear that recessions cause a deceleration in inflation, and if a recession emerges over the coming 12-18 months it will likely happen after supply-side and pandemic-related disinflation has already occurred. That means that inflation is likely to move back to or below the Fed’s target in a recessionary environment. We should note that this assessment differs somewhat from the scenario described by my former colleague Martin Barnes, who wrote a guest report on inflation published in our July Bank Credit Analyst.4 Chart II-13Today’s Pandemic-Related Excess Savings Dwarf Precautionary Savings During The Prior Three Recessions Chart II-14US Corporate Sector Debt Unlikely To Lead To A More Severe Recession, Even In A Higher Yield Environment   Long-Maturity Bond Yields And The Next US Recession What does our analysis imply for long-maturity bond yields and the duration call over the coming few years? In order to judge what is likely to happen to long-maturity bond yields in a recession scenario over the coming 12-18 months, we first project the fair value of the 5-year Treasury yield based on the following hypothetical circumstances: The onset of recession in March 2023 and a peak in the Fed funds rate at a target range of 3.75-4%. A recession duration of eight months, over which time the Fed steadily cuts the policy rate to 0-0.25%. An initial Fed rate hike in September 2024, nine months following the end of the recession, consistent with a relatively short return of the unemployment rate to NAIRU as an expansion takes hold. A rate hike pace of eight quarter-point hikes per year, with the Fed again raising rates to a peak of 4% A longer-term average Fed funds rate of 3%, which we regard as a low estimate. Chart II-15The 5-Year Treasury Yield Would Not Fall Enormously In A Mild Recessionary Scenario Chart II-15 highlights the fair value path for the 5-year Treasury yield in this scenario. Not surprisingly, the fair value today is lower than the current level of the 5-year yield, highlighting that a shift to a long duration stance will be warranted at some point over the coming year if the US economy enters a non-technical, typical income-statement recession. However, the chart also highlights that a long duration position is not likely to be warranted for very long, given that the lowest level of the 5-year fair value path is substantially higher than it was in 2020 and 2021 and is also higher than its 10-year average. Chart II-16 reveals the importance of forecasting the near-term path of interest rates when predicting the likely behavior of long-maturity bond yields. Even though near- and long-term interest rate expectations should be at least somewhat differentiated, the chart highlights that the real 5-year/5-year forward Treasury yield is very closely explained by the real 5-year Treasury yield and a 3-year lag of our adaptive inflation expectations model (which is highly consistent with BCA’s Golden Rule of bond investing framework). Chart II-16 shows that long-maturity bond yields should be higher than they are based on the current level of real 5-year yields and lagged inflation expectations, underscoring the point that we made in Section 1 of our report that significant upside risk exists for long-maturity bond yields in a non-recessionary outcome over the coming year. In a recessionary outcome, it is clear that bond yields will fall as the Fed cuts interest rates, as Chart II-15 demonstrated. But, Chart II-17 highlights that during recessions, there is little precedent for a negative 5-10 yield curve slope outside of the context of the persistently high inflation environment of the late 1960s and 1970s. Applying that template to the fair value path that we showed in Chart II-15 suggests that the 10-year Treasury yield will not fall below 2% during the next recession. As we noted in our August report,5 a 10-year Treasury yield decline to 2% would result in significant performance for long-maturity bonds, but it would not end the structural bear market in bonds that began two years ago – a fact that we suspect would be very surprising to bond-bullish investors. Chart II-165-Year Bond Yields Strongly Explain Yields 5-Years/5-Years Forward Chart II-17There Is Not Much Precedent For A Negative 5/10 Yield Curve During Modern Recessions, Suggesting 10-Year Yields Will Not Fall Below 2% During The Next Recession It is true that bond yields may deviate from the fair value levels shown in Chart II-15 if investors expect a different outcome for the path of the Fed funds rate than we described. However, it is worth noting that changes in our assumed post-recession peak Fed funds rate and the long-term average do not substantially change the outcome shown in Chart II-15. If investors instead assume that the Fed funds rate will peak at 3% during the next expansion, that lowers the fair value path for the 5-year yield by approximately 5 basis points. Changing the long-term average Fed funds rate to 2.4%, the Fed’s current neutral rate expectation, would reduce it by about 25 basis points. These levels would still be significantly above the lows reached in 2011-2013 and in 2020, underscoring that the length of the recession and the speed at which the Fed begins to raise interest rates will be far more important determinants of the path of US Treasury yields. We strongly suspect that investors will recognize that a comparatively mild recession will not result in the same hyper-accomodative monetary policy stance that occurred during the past two recessions, implying that long-maturity bond yields will have less downside during the next recession than may be currently recognized. Investment Conclusions As we have presented, the historical experience suggests that the Fed may cut interest rates to zero during the next recession, but that the re-establishment of a long-lasting zero interest rate policy and the associated resumption of large-scale asset purchases seem quite unlikely unless the recession is severe. In the post-WWII environment, severe US recessions have been accompanied by aggravating factors that appear to be missing in the current environment. In addition to this, there are several arguments pointing to the next US recession being a mild one. In a mild recession scenario, we doubt that the 10-year Treasury yield would fall below 2%, or fall below this level for very long. For fixed-income investors, while bond yields will fall for a time if a recession emerges, the implication is that investors should not overstay their welcome in a long-duration position during the recession and should be looking to reduce their duration exposure earlier rather than later. For equity investors, our findings underscore that meaningful downside risk exists for stocks even in a mild recession environment, because the decline in bond yields is not likely to offset a rise in the equity risk premium. We noted in our July report that if a recession occurred within the coming 6-12 months, that the S&P 500 would likely fall to 3100, even if the recession were average. A mild recession may see the S&P 500 decline less severely than this, but stocks are still likely to incur significant losses during the next recession unless investors price in a much shallower path for short-term interest rates than we believe will be warranted. As noted in Section 1 of our report, we have not yet concluded that a US recession is inevitable over the coming 6-12 months. Still, we acknowledge that the risks are quite elevated, and that substantial (further) supply-side and pandemic-related disinflation is likely needed for the US economy to avoid a contraction in output. Additional changes to our recommended cyclical allocation may thus occur over the coming few months, in response to incoming data, our assessment of the likely implications for monetary policy, and the response of long-maturity government bond yields. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts In contrast to the recent rally in equities, BCA’s equity indicators continue to paint a bearish outlook for stock prices. Our Monetary, Technical, and Speculative indicators have stopped falling, but they remain very weak. Meanwhile, the recent rally has pushed our valuation indicator back towards a level indicating stocks are considerably overvalued. While it is still a risk and not yet a likely event, the odds of a US recession over the next 12 months remain elevated. We maintain a neutral stance for stocks versus bonds over the coming year. Forward earnings are no longer being revised up, but bottom-up analysts’ expectations for earnings are likely still too optimistic. Although earnings growth will be positive over the coming year if a US recession is avoided, it will be in the mid-to-low single-digits given ongoing pressure on profit margins. Within a global equity portfolio, we maintain a neutral stance on cyclicals versus defensives, small caps versus large, and a neutral stance on regional equity allocation. We recommend a modest overweight towards value versus growth stocks, given our recommendation of a modestly short duration stance within a global fixed-income portfolio. Commodity prices have stopped falling, and our composite technical indicator now highlights that commodities are oversold. Our base-case view is that oil prices are likely to rise over the coming 12-months, barring a US recession. Global food prices have come down in the wake of deal between Russia and Ukraine to allow the latter to resume its agricultural exports. But the recent surge in European natural gas prices suggests that global food inflation may remain elevated, given that natural gas is used in the production of fertilizer. Ongoing weakness in the Chinese property market argues for a neutral stance towards industrial metals, until compelling signs of a more aggressive policy response emerge. US and global LEIs have now fallen into negative territory, underscoring that the risk of a global recession is elevated. Some indicators are easing back towards positive territory, such as our global LEI Diffusion Index and our US Financial Conditions Index, but it is not yet clear if they are heralding a reacceleration in economic activity or merely a less intense pace of decline. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Footnotes 1     Please see The Bank Credit Analyst "Is The US Housing Market Signaling An Imminent Recession?" dated May 26, 2022, available at bca.bcaresearch.com 2     Please see US Bond Strategy "The Great Soft Landing Debate," dated August 2, 2022, available at usbs.bcaresearch.com 3    Please see The Bank Credit Analyst "April 2022," dated March 31, 2022, available at bca.bcaresearch.com 4    Please see The Bank Credit Analyst "Inflation Whipsaw Ahead," dated June 30, 2022, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "August 2022," dated July 28, 2022, available at bca.bcaresearch.com

Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge.  In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets.   Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios.  As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report  Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months.   In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. 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 they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins 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 will persist. The Fed will have to raise rates 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 curtail their purchases, 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, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. 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.   Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. 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.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Chart 7 Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting.  Chart 8 Chart 9 Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chart 11 Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade.  In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Chart 13 Chart 14 Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies.  This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Chart 16 Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Chart 18 EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 Chart 20 Chart 21 Chart 22 Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Chart 24 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Chart 26 Chart 27 Chart 28 What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 Chart 30 Chart 31 Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Chart 33 Chart 34 Chart 35 Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Chart 37 EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 Chart 39 Chart 40 Chart 41   Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Listen to a short summary of this report.     Executive Summary Euro Bulls Are Evaporating The euro is likely to undershoot in the near term, as the winter months approach and economic volatility in Europe rises. However, much of the euro’s troubles are well understood and discounted by financial markets. This suggests a floor closer to parity for the EUR/USD. Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year. The forces pressuring equilibrium rates lower in the periphery are slowly dissipating. That should lift the neutral rate of interest in the entire eurozone. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro, but that could change. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Long EUR/GBP 0.846 2021-10-15 -0.13 Short EUR/JPY 141.20 2022-07-07 2.46 Bottom Line: The euro tends to be largely driven by pro-cyclical flows, which will be a positive when risk sentiment picks up. Meanwhile, making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond. Our current stance is more measured because investors could see capitulation selling in the coming months. Feature Chart 1Two Decades After The Creation Of The Euro The creation of the euro was an ambitious project. It began with a simple idea – let’s create the biggest monetary union and everything else will follow, not least, economic might. Over the last two decades, the euro has survived, but its ambitions have been jolted by various crises. Today, the euro is sitting around where it was at the initiation of the project (Chart 1). That has been a tremendous loss in real purchasing power for many of its citizens. Given that we are back to square one, this report examines the prospects for the euro from the lens of its original ambitions, while navigating the economic and geopolitical landscape today. Surviving The Winter Chart 2A European Recession Is Well Priced In Winter will be tough for eurozone citizens. But how tough? In our view, less than what the euro is pricing in. According to the ZEW sentiment index, the eurozone manufacturing PMI should be around 45 today, but sits at 49.8. The euro, which has been tracking the ZEW index tick-for-tick has already priced in a deep recession, worse than the 2020 episode (Chart 2). Bloomberg GDP growth consensus forecasts for the eurozone are still penciling in 2.8% growth for 2022, down from a high of 4%. For 2023, forecasts have hit a low of 0.8%. It is certainly possible that euro area growth undershoots this level, which will cause a knee jerk sell off in the euro. However, much of the euro’s troubles are well understood and discounted by financial markets. Natural gas storage is already close to 80%, the EU’s target, to help the eurozone navigate the winter. Coal plants are firing on all cylinders, and Germany has decided to delay the closure of its nuclear power plants. It is true that electricity prices are soaring, but part of the story has been weather-related, notably a heat wave across Europe, falling water levels along the Rhine that has delayed coal shipments, and lower wind speeds that have affected renewable energy generation. France is also having problems with nuclear power generation, due to little availability of water for cooling reactors. Looking ahead, energy markets are already discounting a steep fall in prices from the winter energy cliff (Chart 3). If that turns out to be true, it will be a welcome fillip for eurozone growth. First, it will ease the need for the ECB to tighten policy aggressively, and second, it will boost real incomes, which will support spending. This is not being discussed in financial markets today. Chart 3AFutures Markets Suggest The Energy Crunch Will Ebb Chart 3CFutures Markets Suggest The Energy Crunch Will Ebb Chart 3BFutures Markets Suggest The Energy Crunch Will Ebb Fiscal Policy To The Rescue? Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year (Chart 4). As funds from the next generation EU plan are being disbursed into strategic sectors, including renewable energy, Europe’s productive capital base will also improve. This is likely to have a huge multiplier effect on European growth. Chart 4AThe Fiscal Drag In The Eurozone Could Be Minimal Chart 4BThe Fiscal Drag In The Eurozone Could Be Minimal Taking a bigger-picture view, what has become evident in recent years is stronger solidarity among eurozone countries, both economically and politically. Related Report  Foreign Exchange StrategyMonth In Review: Inflation Is Still Accelerating Globally Economically, the standard dilemma for the eurozone was that interest rates were too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. As such, the euro was often caught in a tug of war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The good news is that for the eurozone, a lot of this internal rupture has been partly resolved. Labor market reforms have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract since 2008. This has effectively eliminated the competitiveness gap with Germany, accumulated over the last two decades (Chart 5). Italy remains saddled with a rigid and less productive workforce, but the overall adjustments have still come a long way to close a key fissure plaguing the common currency area. The result has been a collapse in peripheral borrowing spreads, relative to Germany (Chart 6). Ergo, interest payments as a share of GDP are now manageable. It is true that Italy remains a basket case but the ECB’s Transmission Protection Instrument (TPI) will ensure that peripheral spreads remain well contained and a liquidity crisis (in Italy) does not morph into a solvency one. Chart 5The Periphery Is Now Competitive Chart 6Peripheral Spreads Are Still Contained In Real Terms Beyond the adjustment in competitiveness, productivity among eurozone countries might also converge. Our European Investment Strategy colleagues suggest that the neutral rate is still wide between Germany and the periphery. That said, gross fixed capital formation in the periphery has been surging relative to core eurozone members (Chart 7). If this capital is deployed in the right sectors, it will have two profound impacts. First, the neutral rate of interest in the eurozone will be lifted from artificially low levels. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates lower in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire eurozone. Over a cyclical horizon, this should be unequivocally bullish for the euro. Second, and more importantly, economic solidarity among eurozone members will help ensure the survival of the euro, over the next decade and beyond. Chart 7The Periphery Could Become More Productive Trading The Euro The above analysis suggests long-term investors should be buying the euro today. However, the long run can be a very long time to be offside. Our trading strategy is as follows: Over the next 6 months, stay neutral to short the euro. The economic landscape for the eurozone remains fraught with risk. This is a typical recipe for a currency to undershoot. Eurozone banks are very sensitive to economic conditions in the eurozone, and ultimately the performance of the euro, and the signal from bank shares remains negative (Chart 8). Chart 8European Banks Are Not Part Of The Agenda Watch Eurozone Banks Investors have been cutting their forecasts for the euro but have not yet capitulated. Bets are that the euro will be at 1.10 by the end of next year, and 14% higher in two years. A bottom will be established when investors cut their forecasts below current spot prices (Chart 9). This corroborates with data from net speculative positions that have yet to hit rock bottom.  Chart 9Euro Bulls Are Evaporating Real interest rates in the euro area are still plunging across the curve, relative to the US. The two-year real yield has hit a cyclical low. Five-year, 10-year and 30-year real yields are also falling. Historically, the euro tends to trend higher when interest rate differentials are moving in favor of the eurozone (Chart 10). Chart 10AReal Rates Are Dropping In The Euro Area Chart 10BReal Rates Are Dropping In The Euro Area Hedging costs have risen tremendously, as the forward market (like investors) is already pricing in an appreciation in the euro. The embedded two-year return for EUR investors is circa 4%, in line with the carry costs (Chart 11). In real terms, the returns are closer to 9% to compensate for much higher inflation expectations in the eurozone. Higher hedging costs will dissuade foreign investors from gobbling up European assets on a hedged basis. Chart 11A 5% Rally In The Euro Is Already Anticipated In short, the euro is likely to enter a capitulation phase. Our sense is that that it will push EUR/USD below parity, towards 0.98. Below that level, we believe the risk/reward profile will become much more attractive for both short- and longer-term investors. Signals From External Demand Chart 12The Euro Is Increasingly Dependant On Chinese Data The eurozone is a very open economy. Exports of goods and services represented 51% of euro area GDP in 2021. This means that what happens with external demand, especially in the US, the UK and China, matters for European growth (Chart 12). Of all its major export partners, China is the biggest question mark. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro. Historically, the Chinese credit impulse has been a good coincident indicator for EUR/USD. Lately, that relationship has decoupled (Chart 13A). We favor the view that the credit transmission mechanism in China is merely delayed, rather than broken. For one, a rising Chinese credit impulse usually leads European exports, and this time should be no different. Chinese bond markets are also becoming more liberalized, and as such are a key signal for financial conditions in China. For over a decade, easing financial conditions have usually been a good signal that import demand is about to improve (Chart 13B). This is good news for European export demand. The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when a few green shoots are emerging for external demand. That may not save the euro in the near term but will be a welcome fillip for euro bulls when it does undershoot. Chart 13AThe Muse For The Euro Is Chinese Data Chart 13BThe Muse For The Euro Is Chinese Data Concluding Thoughts Chart 14The Goldilocks Case For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts are aggressively revising up their earnings estimates for eurozone equities, relative to the US. They might be wrong in the near term, but over a 9-to-12-month horizon, this has been a good leading indicator for the euro.  Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond (Chart 14). Meanwhile, beyond the winter months, inflation could come crashing back to earth in the eurozone, which will provide underlying support for the fair value of the currency. Our near-term stance is more measured because investors are only neutral the euro, and risk reversals are not yet at a nadir. This is particularly relevant given that Europe still has a war in its backyard, with the potential of generating more market volatility ahead. Given this confluence of factors, we have chosen to play euro via two channels: Long EUR/GBP: As we argued last week, the UK has a bigger stagflation problem compared to the eurozone. This trade is also a bet on improving economic fundamentals between the eurozone and the UK, as well as a bet on policy convergence between the two economies. Short EUR/JPY: The yen is even cheaper than the euro. In a risk-off environment, EUR/JPY will sell off. In a risk-on environment, the yen can still benefit since it is oversold. Meanwhile, investors remain bullish EUR/JPY. Long EUR/USD: We will go long the euro if it breaks below 0.98.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Listen to a short summary of this report.     Executive Summary Chart 1The Dollar Has Broken Below The First Line Of Support The softer CPI print in the US boosted growth plays and pushed the DXY index below its 50-day moving average (Feature Chart). This suggests CPI numbers will remain the most important print for currency markets in the coming weeks and months. If US inflation has peaked, then the market will price a less aggressive path for Fed interest rates, which will loosen support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation. This will keep them on a tightening path. This puts the DXY in a tug of war. On the downside, the Fed could turn less hawkish. On the other hand, currencies such as the EUR, GBP and even SEK face high inflation but deteriorating growth. This will depress real rates. Within this context, the most attractive currencies are those with relatively higher real rates, and a real prospect of a turnaround in growth. NOK and AUD stand out as potential candidates. Our short EUR/JPY trade has been performing well in this context. Stick with it.  RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 141.20 2022-07-21 3.29 Bottom Line: Our recommended strategy is a neutral dollar view over the next three months, until it becomes clear inflation has peaked and global growth has bottomed. Feature The DXY index peaked at 108.64 on July 14 and has dropped to 105.1 as we go to press. There have been two critical drivers of this move. First, the 10-year US Treasury yield has fallen from 3.5% to 2.8%. With this week’s all important CPI release, which showed a sharp deceleration in the headline measure, bond yields may well stabilize at current levels for a while. Second, the drop in energy prices has boosted the JPY, SEK and EUR, which are heavily dependent on imported energy. Related Report  Foreign Exchange StrategyA Montreal Conversation On FX Markets Another development has been happening in parallel – as US inflation upside surprises have crested, so has the US price impulse relative to its G10 counterparts (Chart 1). To the extent that this eases market pricing of a hawkish Fed (relative to other G10 central banks), it will continue to diminish upward pressure on the dollar. Much will depend on the incoming inflation prints both in the US, and abroad. With the DXY having broken below its 50-day moving average, the next support level is at 103.6. This is where the 100-day moving average lies, which the dollar tested twice this year before eventually bouncing higher (Chart 2). The next few sections cover the important data releases over the last month in our universe of G10 countries, and implications for currency strategy. What is clear is that most foreign central banks are committed to their tightening campaign, which argues for a neutral stance towards the DXY for now. Chart 1US Inflation Momentum Has Rolled Over Chart 2The Dollar Has Broken Below The First Line Of Support US Dollar: Consolidation Chart 3The Conditions For A Fed Hike Remain In Place The dollar DXY index is up 10% year to date. Over the last month, the DXY index is down 2.1% (panel 1). Incoming data continues to make the case for a strong dollar. Job gains are robust. In June, the US added 372K jobs. The July release was even stronger at 528K jobs. This pushed the unemployment rate to a low of 3.5% (panel 2). Wages continue to soar. Average hourly earnings came in at 5.2% year-on-year in July. The Atlanta Fed wage growth tracker continues to edge higher across all income cohorts (panel 3). The June CPI print was above expectations at 9.1% for headline, with core at 5.9%. The July print for headline that came out this week was 8.5%, below expectations of 8.7%. At 5.9%, the core measure is still well above the Fed’s target (panel 4). June retail sales remained firm, but consumer sentiment continues to weaken. While the University of Michigan current conditions index increase from 53.8 to 58.1 in June, this is well below the January 2020 level of 115. Correspondingly, the Conference Board consumer confidence index fell from 98.7 to 95.7 in July. On June 17, the Fed increased interest rates by 75bps, as expected. The US entered a second consecutive quarter of GDP growth contraction in Q2, falling by an annualized 0.9%. The ISM manufacturing index was flat in July suggesting Q3 GDP is not starting on a particularly strong foot. The Atlanta Fed Q3 GDP growth tracker is, however, printing 2.5%. Unit labor costs are soaring, rising 10.8% in Q2. This is sapping productivity growth, which fell 4.6% in Q2.  The key for the dollar’s outlook is the evolution of US inflation and the labor market. For now, inflation remains sticky, and wages are rising. Meanwhile, labor market conditions remain robust. This will keep the Fed on a tightening path in the near term. We initially went short the DXY index but were stopped out. We remain neutral in the short term, though valuation keeps us bearish over a long-term horizon. The Euro: A European Hard Landing Chart 4The Euro Is At Recession Lows The euro is down 9.2% year to date. Over the last month, the euro is up 2.7%, having faced support a nudge below parity. Incoming data continues to suggest weak economic conditions, with a stagflationary undertone: The ZEW Expectations Survey for July was at -51.1, the lowest reading since 2011 (panel 1). The current account remains in a deficit, at -€4.5bn in May. Consumer confidence continues to plunge. The July reading of -27 is the worst since the 2020 Covid-19 crisis (panel 2). Despite the above data releases, the ECB surprised markets by raising rates 50bps. CPI continues to surprise to the upside. The preliminary CPI print for July came in at 8.9%, well above the previous 8.6% print. PPI in the euro area was at 35.8% in June, a slight decline from the May reading (panel 3). The German Ifo business expectations index fell to 80.3 in July. Historically, that has been consistent with a manufacturing PMI reading of 45 (panel 4). The Sentix confidence index stabilized in August but remains very weak at -25.2. This series tends to be trending, having peaked in July last year. We will see if the next few months continue to show stabilization. The ECB mandate dictates that it will continue to fight soaring inflation. As such, it may have no choice but to generate a Eurozone-wide recession. This is the key risk for the euro since it could push EUR/USD below parity again. We continue to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a risk-on environment, like this week, the yen can still benefit since it is oversold. Meanwhile, investors remain overwhelmingly bearish (panel 5). The Japanese Yen: Quite A Hefty Rally Chart 5Some Green Shoots In Japan The Japanese yen is down 13.4% year-to-date, the worst performing G10 currency (panel 1). Over the last month, the yen is up 3.3%. Incoming data in Japan has been worsening as the rising number of Covid-19 cases is hitting mobility and economic data. According to the Eco Watcher’s survey, sentiment among small and medium-sized Japanese firms deteriorated in July. Current conditions fell from 52.9 to 43.8. The outlook component also declined from 47.6 to 42.8. Machine tool order momentum, one of our favorite measures of external demand, continues to slow. Peak growth was at 141.9% year-on-year in May last year. The preliminary reading from July was at 5.5% (panel 2). Labor cash earnings came in at 2.2% year-on-year, a positive sign. Household spending also rose 3.5%. Rising wages could keep inflation momentum rising in Japan (panel 3). On that note, the Tokyo CPI report for July was also encouraging, with an increase in the core-core measure from 1% to 1.2%. The Tokyo CPI tends to lead nationwide measures. The labor market remains robust. Labor demand exceeds supply by 27%. The Bank of Japan kept monetary policy on hold on July 20th, a policy move that makes sense given incoming data. The BoJ still views a large chunk of inflation in Japan as transitory. For inflation to pick up, wages need to rise. While they are rising, inflation expectations remain well anchored, suggesting little rationale for the BoJ to shift (panel 4). That said, the yen is extremely cheap after being the best short this year (panel 5).  British Pound: Coiled Spring Below 1.20? Chart 6Cable Is Vulnerable The pound is down 9.8% year to date. Over the last month, the pound is up by 2.5%. Sterling broke below a soft floor of 1.20, but quickly bounced back and is now sitting at 1.22, as sentiment picked up (panel 1). We find the UK to have an even bigger stagflation problem than the eurozone. CPI came in at 9.4% in June. The RPI came in at 11.8%. PPI was at 24%. All showed an acceleration from the month of May (panel 2). Nationwide house price inflation has barely rolled over unlike other markets, increasing from 10.7% in June to 11% in July. The Rightmove national asking price was 9.3% higher year-on-year in July, compared to 9.7% in June (panel 3). Meanwhile, mortgage approvals have been in steady decline over the last two years, which points toward stagflation. Retail sales excluding auto and fuel fell 5.9% year-on-year in June, the weakest reading since the Covid-19 crisis. Consumer confidence is lower than in 2020 (panel 4). Trade data continues to be weak, which has dipped the current account towards decade lows (panel 5). The external balance is the biggest driver of the pound, given the huge deficit. The above environment has put the BoE in a stagflationary quagmire. Last week, they raised rates by 50 bps suggesting inflation is a much more important battle than growth. Politically, the resignation of Prime Minister Boris Johnson, and broader difficulties for the Conservative Party, is fueling sterling volatility. We are maintaining our long EUR/GBP trade as a bet that at 1.03, the euro has priced in a recession (well below the 2020 lows), but sterling has not. On cable, 1.20 will prove to be a long-term floor but it will be volatile in the short term.  Australian Dollar: A Contrarian Play Chart 7Relatively Solid Domestic Conditions In Australia The AUD is down 2.3% year-to-date. Over the last month, the AUD is up 5.3%. AUD is fast approaching its 200-day moving average. If that is breached, it could signal that the highs of this year, above 76 cents, are within striking distance (panel 1). Inflation is accelerating in Australia. In Q2, the inflation reading was 6.1%, while the trimmed-mean and weighted-median measures were above the central bank’s 1-3% band (panel 2). As a result, the RBA stated the benchmark rate was “well below” the neutral rate. It increased rates by an additional 50bps in August, lifting the official cash rate to 1.85%. Further rate increases are likely. There are a few reasons for this. First, labor market conditions are the most favorable in decades. In June, unemployment reached 3.5%, its lowest level in 50 years, against a consensus of 3.8% (panel 3). The participation rate also increased to 66.8% in June from 66.7%, which has pushed the underutilization rate to multi-decade lows (panel 4). Despite this, consumer confidence continued its decline in August, dropping to 81.2 from 83.8. A pickup in Covid-19 cases and high consumer prices are the usual suspects. Beyond the labor market, monetary policy seems to be having the desired effect. Demand appears to be slowing as retail sales grew 0.2% month-on-month in June from 0.9%. Home loan issuance declined by 4.4% in June, driven by a 6.3% decline in investment lending. House price growth continued to decline in July, particularly in densely populated regions like Sydney and Melbourne. The manufacturing sector remains strong, with July PMI coming in at 55.7, suggesting the RBA might just be achieving a soft landing in Australia.  The external environment was largely favorable for the AUD in June, as the trade balance increased substantially by A$17.7bn with commodities rallying early in the month. However, commodity prices are rolling over. The price of iron for example, is down 24% from its peak in June. This will likely weigh on the trade balance going forward (panel 5). A weakening external environment are near-term headwinds for the AUD, but we will be buyers on weakness (panel 6).  New Zealand Dollar: Least Preferred G10 Currency Chart 8Near-Term Risks To NZD The NZD is down 6.1% this year. Over the last month, it is up 5% (panel 1). The Reserve Bank of New Zealand raised its official cash rate (OCR) in July by 50bps to 2.5%, in line with market expectations. Policymakers maintained their hawkish stance and guided towards increased tightening until monetary conditions can bring inflation within its target range of 1-3%. Inflation rose in Q2 to 7.3% from a 7.1% forecast, largely driven by rising construction and energy prices (panel 2). As of the latest data, monetary policy appears to be continuing to have the desired effect on interest rate sensitive parts of the economy. REINZ home sales declined 38.1% year-on-year in June. Home price growth continues to roll over (panel 3). The external sector continues to slow. Dairy prices, circa 20% of exports, saw a 12% drop in early August after remaining flat in July. The 12-month trailing trade balance remains in deficit. This is most likely due to a substantial slowdown in Chinese economic activity, given that China is an important trade partner with New Zealand. What is important is that the RBNZ’s “least regrets” approach seems to be working. Despite a cooling economy, sentiment seems to be stabilizing. ANZ consumer confidence improved to 81.9 in July from 80.5. Business confidence also improved to -56.7 from -62.6 (panel 4). Ultimately, the NZD is driven by terms of trade, as well as domestic conditions (panels 1 and 5). Thus, short-term headwinds from a deteriorating external sector do not make us buyers of the currency for now, though a rollover in the dollar will help the kiwi.  Canadian Dollar: Lower Oil, Hawkish BoC Chart 9The BoC Will Stay On A Hawkish Path The CAD is down 1.2% year to date. Over the last month, it is up 1.8%. The Canadian dollar did not fully catch up to oil prices on the upside. Now that crude is rolling over, CAD remains vulnerable, unless the dollar continues to stage a meaningful decline (panel 1). Canadian data has been rather mixed over the last month. For example: There have been two consecutive months of job losses. This is after a string of positive job reports. In July, Canada lost 31K jobs. In June, it lost 43K. The reasons have been mixed, from women dropping out of the labor force, to lower youth participation (the participation rate fell), but this is a trend worth monitoring (panel 2). CPI growth remains elevated and is accelerating both on headline and core measures(panel 3). Building permits and housing starts have started to roll over, as house price inflation continues to lose momentum. June housing starts were at 274K from 287.3K. June building permits also fell 1.5% month-on-month though annual inflation is still outpacing house price growth (panel 4). The Canadian trade balance is improving, hitting a multi-year high of C$5.05 bn in June. This has eased the need for foreign capital inflows. The BoC raised rates 100bps in July, the biggest interest rate increase in one meeting among the G10. Unless the labor market continues to soften, the BoC will continue to focus on inflation, which means more rate hikes are forthcoming. The OIS curve is pricing a peak BoC rate of 3.6% in 9 months (panel 5). Two-year real rates are still higher in the US compared to Canada. And the loonie has lost the tailwind from strong WCS oil prices. As such, unless the dollar softens further, the loonie will remain in a choppy trading pattern like most of this year.  Swiss Franc: A Safe Haven Chart 10The Franc Will Remain Strong Against The Euro For Now CHF is down 3.2% year-to-date and up 4.3% in the past month. The Swiss franc has been particular strong against the euro, with EUR/CHF breaching parity (panel 1). Switzerland remains an island of relative economic stability in the G10. Although slowing, the manufacturing PMI was a healthy 58 in July. The trade surplus was up to CHF 2.6bn in June, despite a strong franc. While most European countries are preparing for a tough winter with energy rationing, prospects for Switzerland, which derives only 13% of its electricity from natural gas, look more favorable.  Still, as a small open economy, Switzerland is feeling the impact of global growth uncertainty. The KOF leading indicator dropped to 90.1 in August with a sharp decline in the manufacturing component. This broader measure suggests the relative resilience of the manufacturing sector might not last long (panel 2). Consumer confidence also fell to the lowest level since the onset of the pandemic. Swiss headline inflation stabilized at 3.4% in July. The core measure rose slightly to the SNB’s 2% target (panel 3). The UBS real estate bubble index rose sharply in Q2, suggesting inflation is not only an imported problem. Labor market conditions also remain tight, with the unemployment rate at 2%, a two-decade low. The SNB will continue to embrace currency strength while inflation risks persist (panel 4), as can be seen by the decline in sight deposits and FX reserves (panel 5). The market is still pricing in another 50 bps hike in September although August inflation data that comes out before the meeting will likely be critical for that decision. CHF is one of the most attractive currencies in our ranking. Despite the recent outperformance, CHF is still down year-to-date against the dollar. A rise in safe-haven demand, and a possible energy crunch in winter will be supportive, especially against the euro.  Norwegian Krone: Oil Fields Are A Jewel Chart 11NOK Will Reap Dividends From Energy Exports NOK is down 7.4% year-to-date and up 7.1% over the last month. It is also up 4.2% versus the euro, despite softer oil prices (panel 1). Inflation in Norway continues to accelerate. In July, CPI grew 6.8% year-on-year, above the market consensus and the Norges Bank’s forecast. Underlying inflation jumped sharply to an all-time high of 4.5%, compared to the Bank’s 3.2% forecast made just over a month ago (panel 2). These figures are adding pressure on the central bank to increase the pace of interest rate hikes, with 50bps looking increasingly likely at the meetings in August and September. NOK jumped on the inflation news. The housing market is starting to show signs of slowing with prices down 0.2% on the month in July, the first decrease since December. This, together with household indebtedness (panel 3), makes the task of policy calibration challenging. Our bias is that a persistently tight labor market and strong wage growth (panel 4) will allow the bank to focus on inflation. Economic activity remains robust in Norway but is softening. The manufacturing PMI fell to 54.6 in July, while industrial production was down 1.7% month-over-month in June. Consumer demand remains frail with retail sales and household consumption flat in June from the previous month. On a more positive note, trade surplus remains near record levels and is likely to stay elevated as high European demand for Norwegian energy is likely to last at least through the winter (panel 5). As global risk sentiment picked up, the krone became the best performing G10 currency over the past month. If the risk appetite reverses, the currency is likely to feel some turbulence. Swedish Krona: Cheap, But No Catalysts Yet Chart 12SEK = EUR On Steroids SEK is down 10% year-to-date and up 5.6% over the past month. The vigorous rebound highlights just how oversold the Swedish krona is (panel 1). The Swedish economy grew 1.4% in Q2 from the previous three months, rebounding from a 0.8% contraction in the first quarter. This is impressive, given high energy prices and a slowdown in global economic activity. Going forward, growth is likely to slow. In July, the services and manufacturing PMIs declined, and consumer confidence fell sharply to the lowest reading in almost 30 years. Retail sales were down 1.2% month-on-month in June. The housing market is also feeling the pain of rising borrowing costs (panel 2). The Riksbank’s latest estimate sees a 16% decline in prices by the end of next year.  For now, inflation is still accelerating in Sweden. CPIF, the Riksbank’s preferred measure, increased from 7.2% to 8.5% in June. Headline inflation rose from 7.3% to 8.7% (panel 3). Headline inflation is likely to decline in July, given the drop in the price component of the PMIs, but inflation will remain well above target. This will keep real rates weak (panel 4). This suggests that the Riksbank is facing the same conundrum as the ECB: accelerate policy tightening and tip the economy towards recession or remain accommodative and risk inflation becoming more entrenched. Our bias is that the Riksbank is likely to frontload rate hikes as currently priced in the OIS curve, with a 50 bps hike in September, ahead of major labor union wage negotiations (panel 5). Much like the NOK, the Swedish krona rebounded strongly in the past month on global risk-on sentiment. Fundamentally, the krona remains more vulnerable to external shocks due to higher energy dependency and a strong dollar. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Executive SummaryWith the fourth Taiwan Strait crisis materializing, the odds of a major war between the world’s great powers have gone up.Our decision trees suggest the odds are around 20%, or double where they stood from the Russian war in Ukraine alone. The world is playing “Russian roulette” … with a five-round revolver.Going forward, our base case is for Taiwan tensions to flatten out (but not fall) after the US and Chinese domestic political events conclude this autumn.However, if China escalates tensions after the twentieth national party congress, then the odds of an invasion will rise significantly.If conflict erupts in Taiwan, then the odds of Russia turning even more aggressive in Europe will rise.Iran is highly likely to pursue nuclear weapons. Not A Lot Of Positive Catalysts In H2 2022Tactical RecommendationInception DateReturnLONG US 10-YEAR TREASURY2022-04-141.3%LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES2022-01-2013.8%Bottom Line: Investors should remain defensively positioned at least until the Chinese party congress and the US midterm election conclude this fall. Geopolitical risk next year will depend on China’s actions in the Taiwan Strait.Feature Chart 1Speculation Rising About WWIIIPessimists who pay attention to world events have grown concerned in recent years about the risk that the third world war might break out. The term has picked up in online searches since 2019, though it is the underlying trend of global multipolarity, rather than the specific crisis events, that justifies the worry (Chart 1).1What are the odds of a major war between the US and China, or the US and Russia? How might that be calculated? In this report we present a series of “decision trees” to formalize the different scenarios and probabilities.If we define WWIII as a war in which the United States engages in direct warfare with either Russia or China, or both, then we arrive at a 20% chance that WWIII will break out in the next couple of years!Those are frighteningly high odds – but history teaches that these odds are not unrealistic and that investors should not be complacent. Political scientist Graham Allison has shown that the odds of a US-China war over the long term are about 75% based on historical analogies.The takeaway is that nations will have to confront this WWIII risk and reject it for the global political environment to improve. Most likely they will do so as WWIII, and the risk of nuclear warfare that it would bring, constitutes the ultimate constraint. But the current behavior of the great powers suggests that they have not recognized their constraints yet and are willing to continue with brinksmanship in the short term.The Odds Of A Chinese Invasion Of TaiwanThe first question is whether China will invade Taiwan. In April 2021 we predicted that the fourth Taiwan Strait crisis would occur within 12-24 months but that it would not devolve into full-scale war. This view is now being tested.In Diagram 1 we provide a decision tree to map out China’s policy options toward Taiwan and assign probabilities to each option.Diagram 1Decision Tree For Fourth Taiwan Strait Crisis (Next 24 Months) While China has achieved the capability to invade Taiwan, the odds of failure remain too high, especially without more progress on its nuclear triad. Hence we give only a 20% chance that China will mobilize for invasion immediately.Needless to say any concrete signs that China is planning an invasion should be taken seriously. Investors and the media dismissed Russia’s military buildup around Ukraine in 2021 to their detriment.At the same time, there is a good chance that the US and China are merely testing the status quo in the Taiwan Strait, which will be reinforced after the current episode. After all, this crisis was the fourth Taiwan Strait crisis – none of the previous crises led to war.If Presidents Biden and Xi Jinping are merely flexing their muscles ahead of important domestic political events this fall, then they have already achieved their objective. No further shows of force are necessary on either side, at least for the next few years.We give 40% odds to this scenario, in which the past week’s tensions will linger but the status quo is reinforced.In that case, the structural problem of the Taiwan Strait would flare up again sometime after the US and Taiwanese presidential elections in 2024, i.e. outside the time frame of the diagram. Unfortunately we are pessimistic over the long run and would give high probability to war in Taiwan.For that reason, we give equal odds (40%) to a deteriorating situation within the coming two years.If China expands drills and sanctions after the party congress, after Xi has consolidated power, then it will be clear that Xi is not merely performing for his domestic audience.Similarly if the Biden administration continues pushing for tighter high-tech export controls against China after the midterm election, and insists that US allies and partners do the same, then the US implicitly believes that China is preparing some kind of offensive operation. The danger of invasion would rise from 20% to 40%.Even in that case, one should still believe that crisis diplomacy between the US and China will prevent full-scale war in 2023-24. But the risk of miscalculation would be very high.The last element of this decision tree holds that China will prefer “gray zone tactics” or hybrid warfare rather than conventional amphibious invasion of the kind witnessed in WWII. The reasons are several.First, amphibious invasions are the most difficult military operations. Second, Chinese forces are inexperienced while the US and its allies are entrenched. Third, hybrid warfare will sow division among the US allies about how best to respond. Fourth, Russia has demonstrated several times over the past 14 years that hybrid warfare works. It is a way of maximizing strategic benefits and minimizing costs.The world knows how the West reacts to small invasions: it uses economic sanctions. It does not yet know how the West reacts to big invasions. So China will be incentivized to take small bites.And yet in Taiwan’s case those tactics may not be sustainable. Our Taiwan decision tree does not account for the likelihood that a hybrid war or “proxy war” will evolve into a major war. But that likelihood is in fact high. So we are hardly overrating the risk of a major US-China war.Bottom Line: Over the next two years, the subjective odds of a US-China proxy war over Taiwan are about 32% while the odds of a direct US-China war are about 4%.The true test comes after Xi Jinping consolidates power at this fall’s party congress.We expect Xi to focus on rebooting the economy so we continue to favor emerging Asian markets excluding China and Taiwan.The Odds Of Russian War With NATOThe second question is whether Russia’s war in Ukraine will morph into a broader war with the West. The odds of a major Russia-West war are greater in this case than in China’s, as a war is already raging, whereas tensions in the Taiwan Strait are merely shadow boxing so far.An investor’s base case should hold that the Ukraine war will remain contained in Ukraine, as Europeans do not want to fight a devastating war with Russia merely because of the Donbas. But things often go wrong in times of war.The critical question is whether Russia will attack any NATO members. That would trigger Article Five of the alliance’s treaty, which holds that “an armed attack against one or more [alliance members] in Europe or North America shall be considered an attack against them all,” justifying the use of armed force if necessary to restore security.Since Russia’s invasion of Ukraine this year, President Biden has repeatedly stated that the US will “defend every inch of NATO territory,” including the Baltic states of Latvia, Lithuania, and Estonia, which joined NATO in 2004. This is not a change of policy but it is the US’s red line and highly likely to be defended. Hence it is a major constraint on Russia.In Diagram 2 we map out Russia’s different options and assign probabilities.Diagram 2Decision Tree For Russia-Ukraine War (Next 24 Months) We give 55% odds that Russia will declare victory after completing the conquest of Ukraine’s Donbas region and the land bridge to Crimea. It will start looking to legitimize its conquests by means of some diplomatic agreement, i.e. a ceasefire. This is our base case for 2023.There is evidence that Russia is already starting to move toward diplomacy.2 The reason is that Russia’s economy is suffering, global commodity prices are falling, Russian blood and treasure are being spent. President Putin will have largely achieved his goal of hobbling Ukraine as long as he controls the mouth of the Dnieper river and the rest of the territory he has invaded.Putin needs to seal his conquests and try to salvage the economy and society. The sooner the better for Russia, so that Europe can be prevented from forming a consensus and implementing a full natural gas embargo in the coming years.However, there is a risk that Putin’s ambition gets the better of him. So we give 35% odds that the invasion expands to southwestern Ukraine, including the strategic port city of Odessa, and to eastern Moldova, where Russian troops are stationed in the breakaway region of Transdniestria.This new campaign would render Ukraine fully landlocked, neutralize Moldova, and give Russia greater maritime access. But it would unify the EU, precipitate a natural gas embargo, and weaken Russia to a point where it could become desperate. It could retaliate and that retaliation could conceivably lead to a broader war.We allot only a 7% chance that Putin attacks Finland or Sweden for attempting to join NATO. Stalin failed in Finland and Putin’s army could not even conquer Kiev. The UK has pledged to support these states, so an attack on them will most likely trigger a war with NATO. A decision to attack Finland would only occur if Russia believed that NATO planned to station military bases there – i.e. Russia’s declared red line.Any Russian attack on the Baltic states is less likely because they are already in NATO. But there is some risk it could happen if Putin grows desperate. We put the risk of a Baltic invasion at 3%.In short, if Russia uses its energy stranglehold on Europe not to negotiate a favorable ceasefire but rather to expand its invasions, then the odds of a broader war will rise.Bottom Line: The result is a 55% chance of de-escalation over the next 24 months, a 35% chance of a small escalation (e.g. Odessa, Moldova), and a 10% chance of major escalation that involves NATO members and likely leads to a NATO-Russia war.Tactically, investors should buy developed-market European currency and assets if the global economy rebounds and Russia makes a clear pivot to halting its military campaign and pursuing ceasefire talks. Cyclically, there needs to be a deeper US-Russia understanding for a durable bull market in European assets.The Odds Of US-Israeli Strikes On IranThe third geopolitical crisis taking place this year could be postponed as we go to press – if President Biden and Ayatollah Ali Khamenei agree to rejoin the 2015 US-Iran nuclear deal. But we remain skeptical.The Biden administration wants to rejoin the 2015 nuclear deal and free up about one million barrels per day of Iranian crude oil to reduce prices at the pump before the midterm election. US grand strategy also wants to engage with Iran and stabilize the Middle East so that the US can pivot to Asia.The EU is proposing the deal since it has even greater need for Iranian resources and wants to prevent Iran from getting nuclear weapons. Russia and China are also supportive as they want to remove US sanctions for trading with Iran and do not necessarily want Iran to get nukes.There is only one problem: Iran needs nuclear weapons to ensure its regime’s survival over the long run.The question is whether Khamenei is willing to authorize a deal with the Americans a second time. The first deal was betrayed at great cost to his regime. President Ebrahim Raisi, who hopes to replace the 83-year-old Khamenei before long, is surely staunchly opposed to wagering his career and personal security on whether Republicans win the 2024 election.Iran has already achieved nuclear breakout capacity – it has enough 60%-enriched uranium to construct nuclear devices – and it is unclear why it would achieve this capacity if it did not ultimately seek to obtain a nuclear deterrent. Especially given that it may someday need to protect its regime from military attacks by the US and its allies.However, our conviction level is medium because President Biden wants to lift sanctions and can do so unilaterally. The Biden administration has not taken any of the preliminary actions to make a deal come together but that could change.3There is a good cyclical case to be made for short-term, stop-gap deal. According to BCA’s Commodity & Energy Strategist Bob Ryan, Saudi Arabia and the UAE only have about 1.5 million barrels of spare oil production capacity between them. The EU oil embargo and western sanctions on Russia will force about two million barrels per day to be stopped, soaking up most of OPEC’s capacity. Hence the Biden administration needs the one million barrels that Iran can bring.We cannot deny that the Iranians may sign a deal to allow Biden to lift sanctions. That would benefit their economy. They could allow nuclear inspectors while secretly shifting their focus to warhead and ballistic missile development. While Iran will not give up the long pursuit of a nuclear deterrent, it is adept at playing for time.Still, Iran’s domestic politics do not support a deal – and its grand strategy only supports a deal if the US can provide credible security guarantees, which the US cannot do because its foreign policy is inconsistent. US grand strategy supports a deal but only if it is verifiable, i.e. not if Iran uses it as cover to pursue a bomb anyway.Iran has not capitulated after three years of maximum US sanctions, a pandemic, and global turmoil. And Iran sees a much greater prospect of extracting strategic benefits from Russia and China now that they have turned aggressive against the West.Moscow and Beijing can be strategic partners due to their shared acrimony toward Washington. Whereas the US can betray the Raisi administration just as easily as it betrayed the Rouhani administration, with the result that the economy would be whipsawed again and the Supreme Leader and the political establishment would be twice the fools in the eyes of the public.Diagram 3 spells out Iran’s choices.Diagram 3Decision Tree For Iran Nuclear Crisis (Next 24 Months) If negotiations collapse (50% odds), then Iran will make a mad dash for a nuclear weapon before the US and Israel attack.If the US and Iran agree to a deal (40%), then Iran might comply with the deal’s terms through the 2024 US election, removing the issue from investor concerns for now. But their long-term interest in obtaining a nuclear deterrent will not change and the conflict will revive after 2024.If talks continue without resolution (10%), Iran will make gradual progress on its nuclear program without the restraints of the deal (though it may not need to make a mad dash).In short, Russia and China need Iran regardless of whether it freezes its nuclear program, whereas the US and Israel will form a balance-of-power Abraham Alliance to contain Iran even if it does freeze its nuclear program.Bottom Line: Investors should allot 40% odds to a short-term, stop-gap US-Iran nuclear deal. The oil price drop would be fleeting. Long-term supply will not be expanded because the US cannot provide Iran with the security guarantees that it needs to halt its nuclear program irreversibly.The Odds Of World War IIINow comes the impossible part, where we try to put these three geopolitical crises together. In what follows we are oversimplifying. But the purpose is to formalize our thinking about the different players and their options.Diagram 4 begins with our conclusions regarding the China/Taiwan conflict, adjusts the odds of a broader Russian war as a result, and adds our view that Iran is highly likely to pursue nuclear weapons. Again the time frame is two years.Diagram 4Decision Tree For World War III (Next 24 Months) The alternate conflict scenario to WWIII consists of “limited wars” – a dangerous concept that refers to hybrid and proxy wars in which the US is not involved, or only involved indirectly. Or it could be a conflict with Iran that does not involve Russia and China.We begin with China because China is the most capable and most ambitious global power today. China’s strategic rise is upsetting the global order and challenging the United States. We also start with China because we have some evidence this year that Russia does not intend to expand the war beyond Ukraine.Either China takes further aggressive action in Taiwan – creating a unique opportunity for Russia to take greater risks – or not. If not, then the odds of WWIII fall precipitously over the two-year period. This scenario is our base case.But if China attacks Taiwan and the US defends Taiwan, we give a high probability to Russia invading the Baltics. If China stages hybrid attacks and the US only supports Taiwan indirectly, then we increase the odds of Russian aggression only marginally.The result is 20% odds of WWIII, i.e. a direct war between the US and Russia, or China, or both. Whether this war could remain limited is debatable. War gaming since 1945 shows that any war between major nuclear powers will more likely escalate than not. But nuclear weapons bring mutually assured destruction, the ultimate constraint. The nuclear escalation risk is why we round down the probability of WWIII in our decision trees.The more likely 59% risk scenario of “limited wars” may seem like a positive outcome but it includes major increases in geopolitical tensions from today’s level, such as a Chinese hybrid war against Taiwan.Bottom Line: According to this exercise the odds of WWIII could be as high as 20%. This is twice the level in our Russia decision tree, which is appropriate given that our Taiwan crisis forecast has materialized.The critical factor is whether Beijing continues escalating the pressure on Taiwan after the party congress this fall. That could unleash a dangerous chain reaction.The global economy and financial markets still face downside risk from geopolitics but 2023 could see improvements if Russia moves toward a ceasefire and China delays action against Taiwan to reboot its economy.Investment TakeawaysWhen Russia invaded Ukraine earlier this year, our colleague Peter Berezin, Chief Global Strategist, argued that the odds of nuclear Armageddon were 10%.At very least this is a reasonable probability for the odds that Russia and NATO come to blows.Now the expected Taiwan crisis has materialized. We guess that the odds of a major war have doubled to 20%.The corollary is an 80% chance of a better outcome. Analytically, we still see Russia as pursuing a limited objective – neutralizing Ukraine so that it cannot be prosperous and militarily powerful – while China also pursues a limited objective – intimidating Taiwan so that it pursues subordination rather than nationhood.Unless these objectives change, we are still far from World War III. The world can live with a hobbled Ukraine and a subordinated Taiwan.However, there can be no denying that the trajectory of global affairs since the 2008 global financial crisis has followed a pathway uncomfortably similar to the lead up to World War II: financial crisis, economic recession, deflation, domestic unrest, currency depreciation, trade protectionism, debt monetization, military buildup, inflation, and wars of aggression. If roulette is the game, then the odds of a global war are one-sixth or 17%, not far from the 20% outcome of our decision trees.Even assuming that we are alarmist, the fact that we can make a cogent, formal argument that the odds of WWIII are as high as 20% suggests that investors should wait for the current tensions over Ukraine and Taiwan to decrease before making large new risky bets.A simple checklist shows that the global macro and geopolitical context is gloomy (Table 1). We need improvement on the checklist before becoming more optimistic.Table 1Not A Lot Of Positive Catalysts In H2 2022  Chart 2Stay Defensively Positioned In H2 2022Specifically what investors need is to be reasonably reassured that Russia will not expand the war to NATO and that China will not invade Taiwan anytime soon.This requires a new diplomatic understanding between the Washington and Moscow and Washington and Beijing that forestalls conflict.That kind of understanding can only be forged in crisis. The relevant crises are under way but not yet complete.There is likely more downside for global equity investors before war risks are dispelled through the usual solution: diplomacy.Wait for concrete and credible improvements to the global system before taking a generally overweight stance toward risky assets. Favor government bonds over stocks, US stocks over global stocks, defensive sectors over cyclicals, and disfavor Chinese and Taiwanese currency and assets (Chart 2).  Matt Gertken Chief Geopolitical Strategistmattg@bcaresearch.com Footnotes1      See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).2     For example, the Turkish brokered deal to ship grain out of Odessa, diplomatic support for rejoining the 2015 Iran nuclear deal, referendums in conquered territories like Kherson, and attempts to build up leverage in arms reduction talks. Cutting off Europe’s energy is ultimately a plan to coerce Europe into settling a ceasefire favorable for Russia.3     Iran is still making extraneous demands – most recently that the IAEA drop a probe into how certain manmade uranium particles appeared in undisclosed nuclear sites in Iran. The IAEA has not dropped this probe and its credibility will suffer if it does. Meanwhile Biden is raising not lowering sanctions on Iran, even though sanction relief is a core Iranian demand. Biden has not removed the Iranian Revolutionary Guards or the Qods Force from the terrorism list. None of these hurdles are prohibitive but we would at least expect to see some movement before changing our view that a deal is more likely to fail than succeed.Strategic ThemesOpen Tactical Positions (0-6 Months)Open Cyclical Recommendations (6-18 Months)Regional Geopolitical Risk Matrix"Batting Average": Geopolitical Strategy Trades ()