Monetary Policy

The kinked Phillips curve not only explains why inflation surged last year but makes a number of surprising predictions, chief of which is that inflation could fall significantly over the coming months without a major increase in the unemployment rate. In the near term, that is bullish for stocks.

BCA’s Emerging Markets Strategy team’s view remains that US inflation will prove to be sticky. That said, in this report, we examine under what conditions a considerable drop in US core inflation, whenever it transpires, would be bullish for stocks. Potentially significant US disinflation would be bullish for stocks if it is due to an improvement in supply-side dynamics, but bearish if it is demand driven.

In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.

Special Report

In this report, we elaborate on why the Chinese central government has been reluctant to open stimulus taps as much as in the past, especially when it comes to the ailing property market. In recent years, there has been a major shift in Beijing’s assessment of the trade-offs between short-term economic growth, sociopolitical stability and the nation's long-term goals. We explain this difficult balancing act, little-known in the global investment community.

We remain bearish on equities. Inflation is a monetary phenomenon that is embedded and perpetuated by a wage-price spiral. The Fed will “keep at it until the job is done.” Economic growth is slowing, and an earnings recession as soon as the end of this year is highly likely. US equities are not cheap and rising rates and slowing earnings growth will take their toll on performance. Don’t fight the Fed!

This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.

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

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

Special Report

A message for Foreign Exchange Strategy clients, There will be no report next week, as we take a summer break. We will be joining our clients and colleagues for our annual investment conference to be held in New York, on September 7 & 8. We will resume our publication the following week, with a Special Report on the Hong Kong dollar, together with our China Investment Strategy colleagues. Looking forward to seeing many of you in person. Kind regards, Chester Ntonifor, Foreign Exchange Strategist Executive Summary No Urgency To Tighten Policy The biggest medium-term threat for Japan remains deflation, rather than inflation. This suggests that the BoJ will be loathe to abandon yield curve control anytime soon. That said, inflation is still accelerating globally, and has meaningfully picked up in Japan. Betting on a hawkish BoJ policy shift could therefore be a significant macro trade. We have identified five conditions that need to be met for the BoJ to begin removing accommodation. None are currently indicating an imminent need to alter monetary policy settings, particularly with the Japanese economy softening alongside subdued inflation expectations. The yen will soar on any hawkish BoJ policy shift. Currently, BCA Foreign Exchange Strategy is short EUR/JPY. That said, the historical evidence suggests waiting for an exhaustion in yen selling pressure, before placing fresh bets on selling USD/JPY. Longer-term bond yields in Japan, for maturities beyond the BoJ yield target, are already moving higher, while speculative interest in shorting JGBs has increased.  We recommend fading these trends for now – shorting JGBs outright will remain a “widowmaker trade”. Bottom Line: The yen has undershot and longer-term investors should buy it - our preferred way to express that view in the near-term is to be short EUR/JPY.  Bond investors should be underweight “low-beta” JGBs in fixed-income portfolios on a tactical basis, not as a hawkish BoJ bet, but because global bond yields are more likely to stay in broad trading ranges than break to new highs. Feature Chart 1The BoJ Is A Lonesome Dove Almost every G10 central bank has raised rates over the last 12 months, even the perennially dovish banks like the ECB and Swiss National Bank, in response to soaring inflation.  The one exception has been the Bank of Japan (BoJ). The BoJ has kept policy rates unchanged throughout the year (Chart 1), while also maintaining its Yield Curve Control policy of capping 10-year Japanese government bond (JGB) yields at 0.25%. There has been interest from the macro investor community on Japan in recent months, betting on the BoJ eventually succumbing to the global monetary tightening trend.  If the BoJ were to shift gears and turn less accommodative, then the yen would surely soar, while JGBs will go on a fire sale. In this report, jointly published by BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy, we explore the necessary conditions that need to be in place for the BoJ to meaningfully shift policy, most likely starting with the end of Yield Curve Control before interest rate hikes. We see five such conditions, which will form a “checklist” to be monitored in the months ahead. Condition 1: Overshooting Inflation Expectations The BoJ has a policy mandate on inflation and most measures of underlying Japanese inflation are still well below its 2% target. For example, the weighted median and mode CPI inflation rates are only at 0.5%, even as headline CPI inflation has climbed to 2.6% on the back of two primarily non-domestic factors – rapidly rising prices for energy and goods (Chart 2). With such low baseline inflation, it has been hard to lift market-based Japanese inflation expectations like CPI swap rates above 1%, even as far out as ten years (Chart 3). CPI swaps have tended to provide a more realistic assessment of underlying Japanese inflation, adhering more closely to trends in realized core CPI inflation, and thus deserve the most attention from the BoJ.  This is in stark contrast to the BoJ’s own consumer survey of inflation expectations, that has consistently overestimated inflation over the years, which is currently showing both 1-year-ahead and 5-year-ahead inflation expectations at a startling, yet highly inaccurate, 5%.  Chart 2Low Underlying Inflation In Japan Chart 3No Unmooring Of Inflation Expectations In Japan The BoJ is likely to side with the more subdued read on market-based inflation expectations in determining if monetary policy needs to turn less dovish – especially with the BoJ’s own estimate of the output gap now at -1.2%, indicating spare capacity in the economy and a lack of underlying inflation pressures (Chart 4). Chart 4Japan Still Suffers From Excess Capacity Condition 2: Excessive Yen Weakness Our more comprehensive measure of determining the pressure to change monetary policy is captured in our central bank monitor for Japan, a.k.a. the BoJ Monitor.  The Monitor includes economic, inflation and financial variables. This measure suggests that the BoJ should not be tightening monetary policy today (Chart 5). One of the variables that goes into our BoJ Monitor is the yen. The yen impacts monetary conditions through two ways. First, import prices tend to rise as the yen weakens, feeding into domestic inflation. In short, it eases monetary conditions. That has been the story over the last year with the yen falling -15% on a trade-weighted basis (Chart 6). The second impact is through profit translation effects. Overseas earnings for Japanese exporters are buffeted in yen terms as the currency depreciates. Both impacts would tend to put more pressure to tighten monetary policy, on the margin. Chart 5No Urgency To Tighten Policy Chart 6Yen Weakness Only Generates Temporary Inflation However, the impact of yen weakness in boosting profit translation costs for Japanese concerns has eased over the years. As many Japanese companies have offshored production, lower wages in Japan have been offset by higher costs abroad. As a result, profit margins for multinational Japanese corporations are not rising meaningfully relative to their G10 peers, despite yen weakness (Chart 7). That puts the central bank in a quandary regarding how to interpret yen weakness vis-à-vis future policy moves. On the one hand, soaring global inflation and a weak yen should be allowing the BoJ to declare victory on rising inflation expectations in Japan. On the other hand, domestic wage growth will not reach “escape velocity” (Chart 8), and inflation will fail to overshoot on a sustainable basis, if corporate profit margins are not rising meaningfully. Chart 7No Widespread Signs Of Increased Profitability From Yen Weakness Chart 8No Escape Velocity Yet In Japanese ##br##Wages Of course, Japanese authorities care about excessive moves in the yen, but they also understand their limited ability to alter the path of the currency. The Ministry of Finance last intervened to support the currency in 1998. That helped the yen temporarily, but global factors dictated its longer-term trend. A BoJ monetary tightening designed solely to stabilize the yen, before inflation expectations stabilize at the BoJ target, is a recipe for failure on both fronts. The bottom line is that yen weakness is giving a lift to inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year just to generate a one percentage point increase in Japanese inflation. As such, the current bout of yen weakness is unlikely to alter the longer-term goals of BoJ policy, unless a wave of selling undermines financial stability. Condition 3: Continually Rising Energy Costs Chart 9Japan Is More Energy Dependent Than Many Other Countries Policy makers in the eurozone have told us that even in the face of a recession, a threat to their credibility on price stability – like the energy-fueled overshoot of European inflation - is worth defending through monetary tightening. Thus, a continued external energy shock could also cause the BoJ to shift. Our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium on oil to increase in the near term. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 9). A rise in energy costs that unanchors inflation expectations is a threat worth monitoring for the BoJ, one that could drag it into monetary tightening as has been the case in Europe. That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent is likely to soften, assuaging energy import costs (Chart 10). Japan is also ramping up nuclear power production, which can help provide alternative sources to imported energy (Chart 11). Chart 10An Unprecedented Arbitrage Chart 11Nuclear Power Could Help? The BoJ would likely not consider an early exit from accommodative monetary policy based solely on energy-fueled inflation.  After all, the current surge in global energy prices, compounded by yen weakness, has barely pushed headline inflation above the BoJ 2% target – with little follow-through into core inflation or wage growth. Condition 4: An Economic Revival In Japan A burst in Japanese growth that absorbs excess capacity and tightens labor market conditions could convince the BoJ that a policy adjustment is due. This could result in higher Japanese interest rates and bond yields.  The yen also tends to appreciate when the Japanese economy is improving (Chart 12). Unfortunately, Japanese growth momentum is going in the wrong direction for that outcome. Chart 12The Yen And the Japanese Economy Domestic demand has been under siege from the lingering effects of the pandemic, including an unprecedented collapse in tourism. As the pandemic effects have faded, however, Japan’s economy faces new threats from slowing global growth, waning export demand, and declining consumer confidence (Chart 13). It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains nearly three percentage points below the level implied by its pre-pandemic trend. While Japan’s unemployment rate is 2.6% and falling, it remains above the low reached just before the start of the pandemic. Chart 13A Broad-Based Slowing Of Japanese Growth What Japan needs now is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Stronger fiscal spending could lift animal spirits in Japan and cause the BoJ to shift. Yet even on that front, the evidence does not point to a direct link from fiscal stimulus to rising inflation expectations – a necessary catalyst for the BoJ to turn more hawkish. A recent study by the Federal Reserve Bank of San Francisco concluded that there was no boost to depressed Japanese inflation expectations from the massive Japanese government fiscal programs during the worst of the 2020 COVID-19 pandemic shock. Waning Japanese economic momentum is not putting any pressure on the BoJ to begin considering a shift to less accommodative monetary settings. Condition 5: More Hawkish Members At The BoJ There are important transitions occurring within the BoJ’s nine-member board that could change the policy bias in a less dovish direction.  In July, two new board members – Hajime Takata and Naoki Tamura – were appointed to the BoJ board. Both brought up the notion of the need for an “exit strategy” from current easy monetary policies at their introductory press conference, although both were also careful to state that they did not think the conditions were in place yet for that to occur. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? Nonetheless, the two new appointees represent a marginally hawkish shift in the policy bias of the BoJ board, especially Takata who replaced one of the more vocal advocates for maintaining aggressive monetary easing, economist Goushi Kataoka.  Of course, the big change at the top of the BoJ will come next April when Governor Haruhiko Kuroda’s current term ends. This will follow the departures of the two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe in March. That means five of nine board members would be changed in less than one year, including the most senior leadership. That would be a huge change for any central bank, but especially for the BoJ where Governor Kuroda has overseen the introduction of all the current aggressive monetary policies, from negative interest rates to massive quantitative easing to Yield Curve Control. A growing constraint for the future of Yield Curve Control As outlined earlier, underlying inflation and growth trends in Japan are nowhere close to justifying an end to Yield Curve Control or even a mere upward tweak of the current 0.25% yield target on 10-year JGBs. However, there are negative spillover effects from the BoJ’s bond market manipulation that could make the current policies less sustainable over the medium term for the new incoming BoJ leadership. We addressed one of those issues earlier with the extreme yen weakness, which is largely a product of the BoJ keeping a lid on Japanese interest rates while almost the entire rest of the world is in a monetary tightening cycle. But another issue to be addressed is the impaired liquidity of the JGB market. After years of steady, aggressive bond buying, the BoJ has essentially “cornered” the JGB market.  The central bank now owns roughly 50% of all outstanding JGBs, doubling its ownership share since Yield Curve Control started in 2016 (Chart 14).  The numbers are even more extreme when focusing on the specific maturity targeted by the BoJ under Yield Curve Control, with the central bank now owning nearly 80% of all 10-year JGBs (Chart 15). Chart 14The BoJ Has Cornered The JGB Market Chart 15BoJ Now Owns 80% Of 10yr JGBs By absorbing so much supply of the main risk-free asset in the Japanese financial system, the BoJ has made life more difficult for Japanese commercial banks, insurance companies and pension funds that require JGBs for regulatory and risk management purposes. In the most recent BoJ survey of bond market participants, 68 of 69 firms surveyed described the JGB market as having poor liquidity conditions, with an equal amount stating that JGB trading conditions were as bad or worse than three months earlier. The change in BoJ leadership could also bring about a change in policymakers’ desire to continue manipulating the JGB market via Yield Curve Control.  Although the BoJ would have to be very careful in how it signals and executes any change to Yield Curve Control.  There is currently a very wide gap between a 10-year JGB yield at 0.25% and a 30-year JGB yield at 1.25% (Chart 16). If the BoJ completely ended Yield Curve Control, the 10-year yield would converge rapidly towards that 30-year yield, likely reaching 1%. That would create a major negative total return shock to the Japanese banks and institutional investors that still own nearly 40% of JGBs. Chart 1610yr JGB Yields Will Surge Without Yield Curve Control A more likely outcome would be the BoJ raising the yield target on the 10-year to something like 0.50%, or perhaps shifting to a different maturity target where the BoJ owns a smaller share of outstanding JGBs like the 5-year sector. Yet without an actual trigger for such a move coming from faster economic growth or core inflation hitting the 2% BoJ target, it is highly unlikely that the BoJ would dare tinker with its yield curve policy, and risk a JGB market blowup, solely over concerns about bond market liquidity. Investment Conclusions None of the items in our newly constructed “BoJ Checklist” are currently indicating that a shift in Japanese monetary policy is imminent.  We therefore see it as being too early to put on the legendary “widowmaker trade” of shorting JGBs, although a case can be made to go long the yen based on longer-term valuation considerations. Japanese yen The carnage in the yen is in an apocalyptic phase, but the BoJ is unlikely to rescue the yen in the near term. As such, short-term traders should be on the sidelines. For longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 17). Meanwhile, according to our PPP models (and a wide variety of others), the Japanese yen is the cheapest G10 currency, undervalued by around -41% (Chart 18). BCA Foreign Exchange Strategy is currently long the yen versus the euro and the Swiss franc. Chart 17The Yen Is On Sale Chart 18The Yen Is Very Cheap JGBs Chart 19Stay Tactically Underweight JGBs In the absence of a bearish domestic monetary policy trigger, JGBs should be treated by global bond investors as a risk management tool as much as anything else. The relative return performance of JGBs versus the Bloomberg Global Treasury Index of government bonds is highly correlated to the momentum of global bond yields (Chart 19). Thus, increasing the exposure to JGBs in a global bond portfolio is akin to reducing the interest rate duration of a bond portfolio – both positions will help a portfolio outperform its benchmark when global bond yields rise. On a tactical basis (3-6 month time horizon), an underweight allocation to JGBs in government bond portfolios seems appropriate, even with JGBs offering relatively attractive yields on a currency-hedged basis, most notably for USD-based investors.  Global bond yields are more likely to stay in broad trading ranges, capped by slowing global growth and decelerating goods inflation but floored by stickier non-goods inflation and hawkish central banks. Thus, the defensive properties of JGBs as a “duration hedge” in global bond portfolios are less necessary in the near-term. Beyond the tactical time horizon, the uncertainty over the potential makeup of new BoJ leadership in 2023, along with some easing of global inflation pressures from the commodity space, could justify lower JGB exposure on a more structural basis - if it appears that a new wave of more hawkish policymakers is set to take over in Tokyo. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

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)