Australia

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter NatGas: Winter Is Coming NatGas: Winter Is Coming Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal NatGas: Winter Is Coming NatGas: Winter Is Coming US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong US Natgas Exports Remain Strong US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth NatGas: Winter Is Coming NatGas: Winter Is Coming Chart 6US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer NatGas: Winter Is Coming NatGas: Winter Is Coming Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps NatGas: Winter Is Coming NatGas: Winter Is Coming The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Aluminum Prices Recovering Aluminum Prices Recovering Chart 10 Weaker USD Supports Gold Weaker USD Supports Gold       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights A lot of pessimism is embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. The key catalyst will be a reversal in COVID-19 infection rates which are holding the Aussie economy hostage. Marginally, there is good news on that front. On a terms-of-trade basis, the Australian dollar is very cheap. Falling commodity prices are a handicap, but the valuation margin of safety makes the AUD a safer bet on a reflationary theme. At the crosses, we are already long AUD/NZD, but AUD/JPY and AUD/CHF should be winners in the next six-to-nine months. Feature The Australian economy was on a strong recovery path before a resurgence in Covid-19 infections handicapped this improvement. Australian GDP recovered to pre-pandemic levels in Q1 and the latest Q2 release suggests the Australian economy was on the path to achieve escape velocity (Chart I-1). Chart I-1The Aussie Economy Has Recovered Is The Australian Dollar A Buy? Is The Australian Dollar A Buy? The bounce in the Australian dollar has mirrored the improvement in the economy. From a low of 55 cents in early 2020, the Aussie rose over 40% to a high of 80 cents in earlier this year. However, more recently, there has been a strong correction in the AUD, reflecting both domestic and global concerns about growth. The key question for investors is whether the decline in the Aussie represents an excessive move or heralds a more malignant outcome for the currency. In our view, if risk sentiment stays ebullient, then the Australian dollar will be a potent candidate for a coiled-spring rebound. However, on the downside, there has already been a lot of bad news priced into the Aussie, making the reward/risk picture more favorable (Chart I-2). The Delta Variant The Delta variant of Covid-19 is ravaging across most countries, and the Australian economy has been particularly susceptible. While in absolute terms, Australia’s infection rates are faring better than most developed markets, the momentum of the latest wave has knocked down a nascent boom in Aussie economic conditions (Chart I-3). Chart I-2The Aussie And Global Stocks Have Diverged The Aussie And Global Stocks Have Diverged The Aussie And Global Stocks Have Diverged Chart I-3The Delta Variant Is Ravaging Australia The Delta Variant Is Ravaging Australia The Delta Variant Is Ravaging Australia   Sydney is now entering its third month of lockdown, and the state of Victoria has just extended mobility restrictions for another three weeks. However, the population is getting vaccinated quickly, with almost 40% having received two jabs. Should the current trajectory of vaccinations continue, Australia could fully lift restrictions on its citizens by the fourth quarter. It is noteworthy that Australia has been here before, and during the last two waves in March and August of last year, the country was able to weather the storm with lower vaccination rates. As such, the latest wave should prove transient, allowing economic conditions to normalize after a weak Q3. AUD And The Global Cycle As a premier commodity producer, the Australian economy is intricately linked to the global economic cycle, especially what happens in China. Chart I-4 shows that both the Caixin and National Bureau of Statistics manufacturing PMIs in China lead Australian manufacturing activity. With the majority of Australian exports going to China, it makes the Aussie economy very sensitive to Chinese domestic conditions. Our China Investment Strategy colleagues believe that fiscal policy will be eased going forward, while the tightening in monetary conditions is past its peak, especially in the face of Covid-19 and floods ravaging China. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it is becoming a good proxy for monetary conditions in China. As such, the trend in bond yields has tended to lead Chinese imports. This suggests that Aussie exports should remain robust in the coming months (Chart I-5). Chart I-4How Long Will The China Slowdown Last? How Long Will The China Slowdown Last? How Long Will The China Slowdown Last? Chart I-5Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Chart I-6Chinese Policy And The AUD Chinese Policy And The AUD Chinese Policy And The AUD A similar pattern to March of last year might be repeated this year, should Covid-19 fears remain persistent. China led the pack vis-à-vis other countries by injecting stimulus much earlier on, which helped ease domestic financial conditions. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil rose higher, helping Australian export volumes. This time around, excess money supply in China is rebounding from extremely depressed levels. While the near-term trajectory suggests some more volatility for the Aussie, the cyclical outlook is improving (Chart I-6). A Terms-Of-Trade Boom Despite a slowing Chinese economy, commodity prices remain resilient. Australian terms-of-trade have outperformed that of other commodity-producing nations (Chart I-7). Australia is relatively competitive in supplying the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, pollutes less, and is in high demand in China. Similarly, Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months. Going forward, Australia’s terms-of-trade improvement is likely to continue. China’s clear energy policy shift away from coal and towards natural gas will buffet LNG export volumes. Also, given that reducing, if not outright eliminating, pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and gas exports. The pattern of an improving terms-of-trade picture but deteriorating domestic fundamentals has placed the AUD in a tug-of-war scenario. One of the key primary drivers of the AUD exchange rate has been the basic balance, the sum of the current account and long-term capital flows. The basic balance is making secular highs, suggesting the AUD should be above its 2011 peak near 1.10 (Chart I-8). This suggests that room for mean reversion is substantive. Chart I-7A Boom In Aussie Terms Of Trade A Boom In Aussie Terms Of Trade A Boom In Aussie Terms Of Trade Chart I-8The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade   In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart I-9). Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, which buffets the currency. Domestic Considerations And The RBA By most accounts, the Reserve Bank of Australia (RBA) has achieved its objectives. Most measures of inflation are near target, unemployment is close to NAIRU, and wages have bottomed and are marginally inflecting higher (Chart I-10). The next batch of numbers coming out of Australia will likely be weak, as the RBA will outline next week, but any weakness in the Aussie will represent a buying opportunity. Chart I-9A Record Surplus In Australias Basic Balance A Record Surplus In Australias Basic Balance A Record Surplus In Australias Basic Balance Chart I-10Fundamentals In The Aussie Economy Are On The Mend Fundamentals In The Aussie Economy Are On The Mend Fundamentals In The Aussie Economy Are On The Mend   Taking a step back, the recovery in the Australian jobs market has been spectacular. Unemployment is at 4.6%, very close to NAIRU. Meanwhile, the participation rate has recovered to pre-pandemic levels as pandemic-aid schemes wear off. The Liberal-National coalition government was very proactive, especially with the “Job Seeker” and “Job Keeper” schemes, providing a valuable cushion for domestic economic conditions. With a very low government debt burden, there is obviously scope to expand the scheme further should conditions dictate. House prices are rebounding in a trajectory the RBA likes to see, driven by credit from owner-occupied housing (Chart I-11). This suggests that at least at the margin, house prices are being driven by domestic demand/supply fundamentals. The key takeaway is that relative to its commodity-currency peers, Australia is well along its house-price adjustment path, having been one of the first developed market countries to introduce macroprudential measures. This suggests that beyond the very near term, emergency policy settings are no longer appropriate for the Aussie economy. The RBA is likely to taper asset purchases from $A5 billion a week, to $A4 billion as telegraphed (Chart I-12), but there is scope for a hawkish surprise at next week’s meeting. Markets are already discounting an increasing path for interest rates starting next year, but not so relative to the US. This could change as the RBA responds to improving economic conditions. Chart I-11A Sustainable Increase In House Prices A Sustainable Increase In House Prices A Sustainable Increase In House Prices Chart I-12The RBA Could Unexpectedly Change Policy Settings The RBA Could Unexpectedly Change Policy Settings The RBA Could Unexpectedly Change Policy Settings   Meanwhile, real rates are already more attractive in Australia compared to the US, especially at the short end of the curve. A Valuation Cushion The cherry on the cake for the Aussie is that it is cheap according to most of our valuation measures. As we highlighted in a recent report, trading the Aussie on a valuation basis alone has added significant alpha over the last several years. One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 20% (Chart I-13). Our intermediate-term timing models, published a fortnight ago, shows the Australian dollar as 9% cheap, or near one standard deviation below the mean. Our purchasing power parity (PPP) models point to a slight undervaluation in the Australian dollar. It also helps that speculators are very short the Aussie, which is bullish from a contrarian perspective (Chart I-14). Chart I-13The AUD Is Cheap The AUD Is Cheap The AUD Is Cheap Chart I-14Investors Are Short The AUD Investors Are Short The AUD Investors Are Short The AUD   How Should Investors Position Themselves? AUD/USD will close its undervaluation gap in the medium-to-long term, as happens with most currencies. This will lift the AUD towards 85 cents. In the short term, long AUD/NZD and long AUD/JPY remain attractive bets for those not willing to take directional dollar bets. In our portfolio, we are already long AUD/NZD for the following reasons: The markets have already priced in a very hawkish RBNZ and a very dovish RBA (Chart I-15). Our bias is that as Covid-19 proves to be a global problem, there will be a renormalization in interest rate expectations. Terms of trade in Australia will continue to outperform that of New Zealand. AUD/NZD and relative terms of trade tend to move together (Chart I-16). Chart I-15AUD/NZD Remains A Buy AUD/NZD Remains A Buy AUD/NZD Remains A Buy Chart I-16Terms Of Trade And AUD/NZD Terms Of Trade And AUD/NZD Terms Of Trade And AUD/NZD   AUD/NZD is very cheap on a historical basis. This level of valuation has provided strong support in the past (Chart I-17). Meanwhile, the Australian yield curve has steepened, albeit with some recent flattening, but banks have still underperformed the improvement in the interest rate term structure (Chart I-18). A bottoming economy will benefit banks, which make up almost 35% of the Australian MSCI index, and thus there could be renewed foreign inflows. Chart I-17AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap Chart I-18Stay Long Aussie Banks Stay Long Aussie Banks Stay Long Aussie Banks   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was mixed: The payrolls report was well below expectations. Non-farm payrolls came in at 235K, versus an expected increase of 733K. Both the labor force participation rate and average hourly earnings remained steady at 61.7% and 4.3% year-on-year, respectively. The ISM report was robust for August. The manufacturing PMI improved from 59.5 to 59.9. New orders rose from 64.9 to 66.7 The PCE deflator came it at 3.6% year-on-year, in line with estimates. The US dollar DXY index fell this week. The weak payrolls report reiterates the fact that risks from tighter monetary policy in the US are overstated. This was the conclusion from the Jackson Hole meeting last week, that saw a drop in both the US dollar and bond yields. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data remains robust: Core CPI came in at 1.6% year-on-year in August. Headline CPI was a more robust 3%. The final read from the Markit manufacturing PMI remained at a robust 61.4 in August. The services PMI did decline from 59.5 to 59. Retail sales increased by a robust 3.1% in July. The euro rose by almost 1% this week. Covid-19 cases seem to be rolling over in Europe while firing in other nations. This will increase support for the euro, as well as expectations the ECB could dial back monetary accommodation. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been on the strong side: Retail sales rose 2.4% year-on-year in July. The employment report was strong. The unemployment rate fell to 2.85 and the job-to-applicant ratio rose from 1.13 to 1.15. Housing starts rose 10% year-on-year in July. Capital spending for Q2 was 5.3% year-on-year, well above expectations. The yen was flat against the dollar this week. In an environment where global risk is ebullient, the yen tends to underperform other pro-cyclical currencies. This was very evident this week. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data out of the UK this week was encouraging: The Lloyds business barometer improved from 30 to 36. Nationwide home prices rose 11% year-on-year in August. The Markit services PMI was steady at 55 in August. The pound rose by 0.6% this week. UK will continue to benefit from higher vaccination rates, compared to the rest of the G10. That said, other pro-cyclical currencies, such as the AUD, could benefit from a robust vaccination campaign, outperforming GBP. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data is slated to slow, but the recent numbers have been encouraging: Private sector credit rose 4% year-on-year in August. Q2 GDP was a robust 9.6% year-on-year. Exports rose 5% month-on-month in July. The AUD was the best-performing currency this week, rising almost 2%. We discuss the AUD at length in this week’s front section. Our bias is that the AUD will benefit from easing monetary policy in China and high commodity prices. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: Building permits rose 2.1% month-on-month in July. CoreLogic house prices are inflecting 27% year-on-year in August. ANZ Business confidence slipped from -3.8 to -14.2 in August. The NZD was up almost 2% this week. We like the NZD cyclically, but our bias is that hawkish expectations from the RBNZ could be watered down, which could make the kiwi lag other commodity currencies like the Aussie. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been weak: Q2 GDP missed expectations, falling 1.1% versus an expected increase of 2.5%. The Markit manufacturing PMI increased from 56.2 to 57.2 in August. Net trade deteriorated in July, but Canada is still booking a C$0.8bn surplus. The CAD rose by 0.7% this week. The backdrop for the loonie is positive as the Bank of Canada continues to taper asset purchases and remains on a path to increase interest rates. The upcoming election could also usher in more fiscal stimulus for Canada. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The data out of Switzerland this week was weak: The KOF indicator declined from 129.8 to 113.5 in August. This was well below expectations. CPI in August was slightly above expectations at 0.4% year-on-year for the core and 0.9% for headline. GDP for Q2 was in line with expectations, at 1.8% quarter-on-quarter. The Swiss franc was flat this week. The franc will continue to benefit from rolling bouts of volatility, but at the margin, it will lag the bounce in other currencies as global risk sentiment stays ebullient. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data out of Norway this week was positive: Credit growth improved 5.3% year-on-year in July The current account balance was a healthy NOK 93.2bn in June. The unemployment rate fell from 3.1% to 2.7%. The NOK was up around 1% this week. We are long Scandinavian currencies on a bet that the dollar will fall cyclically. Meanwhile, the Norges Bank has signaled they will increase interest rates ahead of both the Federal Reserve and the ECB. This will benefit real rates in Norway. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been improving: The Swedbank manufacturing and services PMI remained robust in August at 60.1 and 64.7 respectively. The August current account balance showed a healthy surplus of SEK 80.3 billion. The economic tendency survey for August came in at 121.1 from 119.8. Consumer confidence rose from 106.5 to 108.6 in August. The SEK was up almost 1% this week. There are many signs the Swedish economy is improving. This is paring back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades Footnotes

Highlights The dollar is fighting a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. The litmus test for determining which force will gain the upper hand is if the DXY fails to break above the 93-94 level that marked the March highs. So far that appears to be the case. In the interim, investors can capitalize on a few themes that will ultimately unfold: an end to the China slowdown, a bet on real rates staying low for longer, and a play on the Olympics. The expressions of these themes are long AUD/MXN, long silver and long the yen, respectively. Natural disasters are also rising in frequency globally. Historically, this has coincided with rising currency volatility. Long CHF/NZD positions can be a potent play on this trend. We ultimately expect the dollar lower 9-12 months from now. The best currencies to express this view today are NOK and SEK. Feature We are a month into the second half of year, and it is instructive to revisit the dollar view and our roadmap towards year-end. As a starting point, two key themes are propping the dollar on a tactical basis: The first is a global economic slowdown, one that could be exacerbated by increased infections of the COVID-19 Delta variant. The dollar tends to rise in an environment where global growth is weak. This is especially the case when US growth is relatively resilient, like now (Chart I-1). The second is the resilience of the US equity market, not only due to superior earnings, but also as regulatory crackdowns hit shares in China specifically, and emerging markets in general. Equity inflows into the US were a key reason the dollar did not collapse in 2020. Renewed inflows into US equities will be particularly beneficial for the dollar (Chart I-2). This will especially be the case if technology and healthcare earnings keep surprising to the upside. Chart I-1The Dollar And Relative Economic Momentum The Dollar And Relative Economic Momentum The Dollar And Relative Economic Momentum Chart I-2The US Is Leading The Earnings ##br##Cycle The US Is Leading The Earnings Cycle The US Is Leading The Earnings Cycle At the same time, real interest rates in the US are very depressed. In its latest meeting, the Federal Reserve reiterated that it will keep running the economy hot, a thesis central to our bearish dollar view. This puts the dollar in a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. Arbitrating The Tug Of War Historically, unless the world economy experiences a recession, the interest rate story has dominated currency market action. Our report last week showed that real interest rates matter for currencies both short term and longer term. Given our bias that global growth will moderate rather than contract, the future path of interest rates will once again become important for currency market action. In this light, lower real rates are negative for the US dollar. How long the outperformance of US equities will last is a tougher call. What we do know is that in a rising interest rate environment, the US equity market has tended to derate relative to the rest of the world. Our base case is that bond yields will be higher globally on a cyclical horizon, suggesting investors should fade the current outperformance of US equities. Scandinavian Currencies As A Strategic Dollar Play The best currencies to express a cyclically lower dollar are the NOK and SEK, for a few reasons other than the strong correlation with the DXY index (Chart I-3): Chart I-3NOK And SEK Are A Play On DXY NOK and SEK Are A Play On DXY NOK and SEK Are A Play On DXY Economic momentum in both Norway and Sweden is picking up steam. In Norway, high oil prices will be a cyclical boost to the currency, as has been the case historically. Meanwhile, Sweden is benefiting from a strong manufacturing landscape, especially in autos where pricing has skyrocketed due to shortages. While the Swedish manufacturing PMI has moderated recently, it still sits at 65.8, the highest level since the mid-1990s. Both currencies remain very cheap according to our models. Our favored PPP model shows that NOK and SEK are trading at a discount of 20% and 17% respectively, amongst the cheapest in the G10 (Chart I-4). Chart I-4The Dollar Is Expensive Trade Themes Into Year End Trade Themes Into Year End Norway, Sweden and Canada are among the countries whose output gaps are expected to close relatively fast (Chart I-5). In the case of Norway (and Canada), the central bank has been vocal about curtailing monetary accommodation, as market conditions improve. The upside surprise in Swedish GDP this week lowers the odds of more monetary accommodation from the Riksbank. This will boost real rates in these countries, supporting their currencies. Chart I-5Output Gaps Across The G10 Trade Themes Into Year End Trade Themes Into Year End In a nutshell, if the dollar heads lower 9-12 months from now, this will benefit most procyclical currencies, with the NOK and SEK as winners. The Yen As An Olympian Chart I-6Currencies And The Olympics Trade Themes Into Year End Trade Themes Into Year End We made the case last month that the yen was the most underappreciated G10 currency, and that certainly remains true.  Since then, there has been improvement in the Japanese economy: The vaccination campaign is progressing smoothly, with 27% of the population having been inoculated from almost nil earlier this year. Meanwhile, about 38% have received at least one dose. This should curtail hospitalizations, despite the increase in new cases. Economic momentum remains tepid, but there are green shoots. Real cash earnings are inflecting higher, which is boosting household spending. There was also remarkable improvement in the Eco Watchers Survey, a sign of optimism among small and medium-sized businesses. Global trade remains strong, which is a boost to the Japanese external sector. While this may slow going forward, it will be a benign headwind. Japan is less exposed to China, a key market for exports, compared to its developed market peers like Australia and New Zealand. Meanwhile, China is already easing policy at the margin. The true catalyst for the yen could be the Olympics. Since the 1970s, the median performance of a currency hosting the Olympics is 4% over a year. The performance of the yen today falls well below the 25th percentile of this performance gap (Chart I-6). This year’s games have obviously been unique given the pandemic but given that the yen is the most shorted G10 currency, this is probably already in the price. It also it does raise the prospect that the yen rises from being an underdog to staging a powerful mean reversion rally. While Japan will not get a tourism boost this summer that will buffet discretionary spending, foreigners are likely to return as the pandemic is put behind us. It is remarkable that Japanese shares, even construction and material companies, that should have benefited from the leadup to the Olympics, have massively underperformed (Chart I-7). This suggests that at the margin, many investors have folded hands and sold Japanese equities indiscriminately. Chart I-7Japanese Shares Have Underperformed Japanese Shares Have Underperformed Japanese Shares Have Underperformed Finally, real rates in Japan are among the highest in the G10. This will not only prevent Japanese concerns from deploying yen cash on foreign paper, but could also lead to some repatriation of funds, boosting the yen. Low Real Rates: Buy Silver (And Platinum) The case for buying silver has become compelling, at least on a tactical basis. First, the runup in prices from under $12/oz in March to almost $30/oz in August ushered silver into a well-defined wedge formation, with a series of higher lows. We are now sitting close to the lower bound of this wedge. Given our expectation that any DXY rally will be capped at 93-94, this puts a solid floor under silver prices around the $22-$23/oz level (Chart I-8). This makes for an attractive risk/reward since silver could overtake its 2011 highs near $50/oz, once strong resistance at $30/oz is breached. Second, similar to gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for fiat money debasement. But unlike gold or even cryptocurrencies, physical use for silver is quite elevated. Silver fabrication demand benefits from electronic production (whereby there is a shortage, so it is bound to eventually increase), as well as new green industries such as solar power that are dominating the manufacturing landscape (Chart I-9). Meanwhile, our Commodity & Energy Strategists have flagged that the surplus of silver is expected to shrink significantly this year, driven by both industrial and investment demand (Chart I-10). Chart I-8Buy Some Silver Buy Some Silver Buy Some Silver Chart I-9Silver Demand Is Picking Up Trade Themes Into Year End Trade Themes Into Year End Chart I-10The Silver Surplus Is Shrinking Trade Themes Into Year End Trade Themes Into Year End Third, silver is also a more potent play on a lower dollar. This is because the silver market is thinner and more volatile, with futures open interest at about one-third that of gold. Put another way, volatility in silver has always been historically higher than gold, which is why silver tends to outperform gold when the dollar is falling (Chart I-11). Chart I-11Silver Is A More Potent Play On The Dollar Silver Is A More Potent Play On The Dollar Silver Is A More Potent Play On The Dollar It is worth pointing out that the velocity of money between the US and China is slowing again, suggesting growth is likely to start outperforming outside the US, beyond the current slowdown. The US benefits less from a pickup in Chinese growth, compared to other countries. This has generally pushed the dollar lower and set fire under the silver/gold ratio (Chart I-12). Finally, there is also a case to be made for platinum. It has lagged both gold and palladium prices (Chart I-13). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart I-12Money Velocity And The GSR Money Velocity And The GSR Money Velocity And The GSR Chart I-13Platinum And Silver Have Lagged Gold Platinum And Silver Have Lagged Gold Platinum And Silver Have Lagged Gold China Slowdown Almost Over: Buy AUD/MXN Soon We highlighted in February that a tactical opportunity had opened to go short the AUD/MXN cross. With the cross down 11% from its recent highs, an opportunity to go long will soon open up. China has started easing policy at the margin. The AUD/MXN cross correlates quite strongly with the Chinese credit cycle, as Australia is economically tied to China while Mexico depends more on the US (Chart I-14). The Australian PMI has remained quite firm, despite a slowdown in the Chinese credit impulse. Strong commodity prices have been a factor, but it also points to endogenous strength in the Aussie economy. Relative terms of trade favor the Aussie. We had expected terms of trade between Australia and Mexico to relapse on the basis of destocking in China, but that has not been the case (Chart I-15). With oil prices structurally challenged by EVs, while metal prices benefit from the buildout of green infrastructure, terms of trade will remain favorable for the cross longer term. Australian stocks have been underperforming the more defensive Mexican bourse (Chart I-16). This should reverse as cyclicals start to regain the upper hand. Chart I-14AUD/MXN Tracks Chinese Credit AUD/MXN Tracks Chinese Credit AUD/MXN Tracks Chinese Credit Chart I-15AUD/MXN And Terms Of Trade AUD/MXN And Terms Of Trade AUD/MXN And Terms Of Trade Chart I-16AUD/MXN And Relative Equity Prices AUD/MXN And Relative Equity Prices AUD/MXN And Relative Equity Prices The timing for a long position is tricky as Chinese economic activity is likely to slow in the coming months, and cyclical equities could remain under pressure. Meanwhile, as value investors, we are also uncomfortable with AUD/MXN valuations. This suggests that in the very near term, short positions still make sense. That said, the 13-14 zone should provide formidable support to go long, an opportunity likely to unfold in the next 3 months (Chart 17).  Chart I-17AUD/MXN And Momentum AUD/MXN And Momentum AUD/MXN And Momentum A Final Thought On Rising Catastrophes We have been watching with obvious trepidation the rising incidence of catastrophes globally. The occurrence of weather events such as droughts, floods, storms, cyclones, and wildfires has been skyrocketing (Chart I-18). Chart I-18Disasters And Volatility Trade Themes Into Year End Trade Themes Into Year End The direct play is to buy global construction and machinery stocks that are likely to benefit from increased reconstruction activity. It also favors agricultural futures. As for currency markets, the one observation is rising volatility with the VIX having spiked significantly in the years with numerous weather events.  We are already long CHF/NZD and the yen as a play on rising currency volatility, and we will be exploring this thesis more deeply in future publications.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was relatively robust: The Markit manufacturing PMI for July edged up from 62.1 to 63.1. That said, the services PMI fell from 64.6 to 59.8. Durable goods orders were rather weak, rising 0.8% year on year in June, versus a consensus of a 2.2% increase. Admittedly, the core non-defense measure, excluding aircraft and parts, rose by 0.5% from 0.1%. Consumer confidence remains resilient, rising from 127.3 to 129.1 in July, well above expectations. Q2 GDP came in at 6.5% quarter on quarter, versus an 8.4% consensus. The US dollar DXY index fell this week. The Fed meeting highlighted that the authorities are in no rush to tighten monetary policy, despite what has been a robust recovery in labor market conditions and inflation. The aftermath of the meeting saw a drop in US real yields and the dollar. The Fed’s dovish stance has been a central theme to our bearish dollar view. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of the eurozone this week softened: The manufacturing PMI fell to 62.6 in July from 63.4. The services PMI surprisingly improved, rising from 58.3 to 60.4 in July. Economic confidence rose from 117.9 to 119 in July. The German IFO survey was below consensus in July, but the expectations component did rise from 99.6 to 100.4. The euro rose by 1% this week. We went long the euro at 1.18 on expectations that at the margin, monetary policy in the euro area will shift in a more hawkish fashion. Since then, the ECB has adopted a symmetric inflation target, promising to keep interest rates low for longer. The euro’s indifference to this dovish development suggests a strong floor under the currency, and upside should euro area growth beat consensus. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data was rather mixed this week: The Jibun manufacturing PMI eased slightly in July, to 52.2 from 52.4. The services component also fell to 46.4. Department store sales came in at 3.7% year on year in June. We highlighted last week that supermarket sales also remain strong. The yen was up 0.4% against the dollar this week. In the history of the Olympics, the incumbent currency has tended to rise over the course of the year. Given the yen is the most shorted developed-market currency currently, this sets it up for a coiled spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There were some mixed data out of the UK this week: Retail sales in the UK were in line with expectations. The measure excluding automobiles and fuel rose by 7.4% year on year in June. The PMIs generally slowed from very strong levels. The manufacturing print for July was 60.4, while the services component came in at 57.8. House price inflation remains strong, with the nationwide measure coming in at 10.5% year on year in July. Mortgage approvals fell slightly in June but remain at a robust 81.3K. The pound rose by 1.5% this week. The big surprise in the UK has been a reversal in the COVID-19 infection rate, despite an economy that is reopening quite briskly. This sets cable up for a volatile few weeks and months, given a poor technical picture (speculations are cutting long positions from very aggressive levels). We like GBP long term but will stand aside for now. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The inflation report in Australia was in line with expectations for Q2: Headline CPI rose from 1.1% to 3.8%. The trimmed mean and median measure came in at 1.6% and 1.7% respectively. The AUD was flat this week, the worst performing G10 currency. The dominant story remains the renewed restrictions from a resurgence in COVID-19, particularly in Sydney. That said, weakness in AUD is starting to create an attractive reward/risk profile. Speculators are net short the Australian dollar, and our bias is that there has been spillover pressure from the recent turmoil in Asian/Chinese markets. In the end, this only makes for a coiled spring rebound in the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: The trade balance came in at NZ$261 million, even with stronger imports in June. The ANZ activity outlook index fell in July, to 26.3 from 31.6. The NZD was up 0.5% this week. The strong rally in NZD after a hawkish RBNZ a fortnight ago continues to fade. This week, we highlighted a new theme, which is the rising incidence of natural disasters. Historically, this has been great for agricultural prices, benefiting NZD. But it has also been accompanied by a tremendous rise in currency volatility, which hurts the NZD vis-à-vis safe-haven currencies. We are currently long CHF/NZD and will be exploring this theme in future publications. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been mixed: Retail sales fell month on month in May by 2.1% but this was above expectations. Inflation remains robust. Headline CPI was 3.1%, while the core trim, median and common measures came in at 2.6%, 2.4% and 1.7% respectively. The CAD rose by 0.8% this week. The backdrop for the loonie remains positive as the Bank of Canada is leaning against monetary accommodation by tapering asset purchases, and signaling interest rate increases, while the Fed remains on hold. These pin real interest rate differentials in favor of the loonie. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Investor confidence from the Credit Suisse survey fell in July, from 51.3 to 42.8. Total sight deposits were unchanged at CHF 712 bn for the week of July 23. The Swiss franc was up 1.3% this week. Incoming Swiss inflation data next week will dictate whether the SNB steps up the pace of FX intervention. So far, there have been no big moves in the CHF exchange rate to implore central bank attention. A rebound in global bond yields will be a welcome relief since the franc tends to weaken in that environment. For the time being, we believe volatility can continue to rise. As such, the franc will benefit, justifying long CHF/NZD bets. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: Retail sales were flat month on month in June. The NOK was up 1% this week. Our limit buy on Scandinavian currencies was triggered a fortnight ago, nudging us in the money with this week’s currency moves. We are not fighting the Norges Bank, which has signaled they will increase interest rates this year, ahead of both the Federal Reserve and the ECB. As such, we are short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been improving: The PPI for July came in at 9.6%, up from 7.9%. The June trade balance showed a healthy surplus of SEK 10.3 billion. The economic tendency survey for July came in at 122.4 from 119.8. Manufacturing confidence continues to inflect higher, rising from 125.2 to 129.2 in July. The SEK was the strongest performing G10 currency this week, rising 1.5%. Swedish Q2 GDP was a welcome positive surprise, up by 10.5% year on year and 0.9% quarter on quarter. This is paring back expectations of more stimulus from the Riksbank. We have been highlighting that SEK remains one of our most potent plays on a global growth recovery. As such, we are short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Metals prices are likely to suffer in the short term on the back of weakening Chinese demand and fading inflationary pressures. Accordingly, in our most recent Global Asset Allocation (GAA) Quarterly Outlook, we downgraded the AUD to underweight against the greenback. Bond yields, globally, are bound to rise moderately over the course of the coming 12 months. Australian yields, however, are likely to rise slower than those in the US. The RBA has been explicit in communicating what it would take to adjust its policy stance and is likely to lag behind other central banks in DM. We therefore recommend investors favor Australian government bonds in a global bond portfolio. Australian equities, now dominated by Financials rather than the Materials sector, would benefit from a rise in bond yields. However, a weaker AUD and declining metal prices warrant no more than a benchmark exposure to Australian equities within a global equity portfolio. Introduction Recently, clients have often been asking about Australia. The reasons seem clear. With a potential commodities “super-cycle” driven by a shift to renewable energy and electric vehicles (EVs), both the Australian economy and equities should be in a position to benefit. The reality, however, has been much less positive. Particularly the divergence between the core driver of the Australian market, industrial metals, and the performance of both equities and the currency over the past few years has been a concern (Chart 1). Over the past year and a half, Australian equities have underperformed the MSCI ACWI by 12.4% (Chart 2, panel 1). This underperformance was mainly due to the outperformance of the US. However, even against global markets excluding the US, Australian equities did not match the rise in commodity prices – particularly industrial metals (Chart 2, panel 2). Chart 1Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Chart 2...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed   Chart 3Financials Dominate Australian Equities Financials Dominate Australian Equities Financials Dominate Australian Equities The structure of the Australian market has changed over the past few years. The commodities boom and subsequent global liquidity boom over the past two decades have fueled a housing bubble in Australia and an unsustainable rise in household debt. As a result, Australian equities are no longer dominated by metals and mining stocks, but rather by banks (Chart 3). We structured this Special Report in a Q&A format, answering questions we think are most relevant for investors to assess both the short- and long-term outlook for Australia. We aim to provide an overview of the economy and draw some conclusions on how investors should be positioned. Our conclusions are as follows: Over the past year and a half, the Australian economy has shown how complementary actions between fiscal and monetary policy, as well as social restriction measures, can mitigate both economic and human damage. The Reserve Bank of Australia (RBA) will be in no rush to adjust its policy stance until wage growth is back to its 3% target. However, RBA officials risk running the economy hot in the meantime given that measures of employment are back to their pre-pandemic levels. The RBA is not likely to change its policy stance before reaching its wage growth and inflation targets and will probably lag behind other global central banks in tightening. In that case, investors should favor Australian government bonds in a global bond portfolio. Australian banks remain well-funded and in good health. But their excessive exposure to the housing sector puts them at grave risk if home prices collapse. Despite this, there seems to be a feedback loop where a decline in mortgage rates fuels further demand for loans, pushing up home prices. A slowdown in Chinese credit growth and economic activity will hamper commodity demand, weighing down on Australian equities. The longer-term outlook remains compelling for Australian equities and metals as we enter into a new commodities “supercycle” fueled by a transition to renewable and alternative energy. The Australian economy stands to benefit given that the country has high levels of both production and reserves of the minerals needed for this transition.   Q: How Does The Economy Look In The Short-Term? A: Australia can be regarded as one of the few countries that successfully navigated the pandemic with a minimal amount of damage, both to its population and economy. With swift measures to limit travel and implement social restrictions, the spread of the outbreak was curtailed to slightly over 30,000 total cases, representing only 0.12% of its population (Chart 4). On the other hand, its vaccination campaign has been much slower (at 38 doses administered per 100 people) than in other DM economies such as the US, UK, France, or Germany with 100, 120, 90, and 102 doses per 100 people, respectively. In the short term, this might not seem particularly damaging to the economy. However, if vaccination rates do not pick up rapidly, Australia’s international travel restrictions (which cannot sustainably be kept in place) will hamper economic growth and become a major drag on the tourism and education sectors (Chart 5, panels 1 & 2). Chart 4Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Chart 5...At The Expense Of Tourism ...At The Expense Of Tourism ...At The Expense Of Tourism Ample fiscal support – in the form of wage subsidies and business support through the JobKeeper program – mitigated the shortfall in household incomes (Chart 6). This provided a boost to both consumers and businesses with Q1 GDP growth coming in at 1.8% quarter-on-quarter (7.4% annualized). GDP expectations for the remainder of this year and next show a resilient strong momentum for Australian growth and domestic demand (Chart 7). Chart 6Fiscal Stimulus Supported Employment... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 7...And Overall Growth ...And Overall Growth ...And Overall Growth Chart 8Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels...   The labor market recovery has been an excellent example of how fiscal support and lockdown measures complement each other. Most employment indicators have almost recovered or surpassed their pre-pandemic levels: The unemployment rate stands at 4.90%, compared to 5.13%, the underemployment rate is at 7.44%, compared to 8.60%. The total number of those employed is now above its pre-pandemic level, albeit still below the 2018-2019 growth trend (Chart 8).   Q: When Will The RBA Shift Its Policy Stance? A: The RBA has been explicit in communicating that changes in its policy stance hinge on Australian wage growth rising sustainably towards 3% – a level last reached in Q1 2013. Even with economic activity mostly restored, wage growth remains low at 1.49% (Chart 9). Our belief is that until that occurs, the RBA will probably maintain its accommodative stance. Our global fixed-income strategists, in a recent report, highlighted their belief that the RBA is likely to be less hawkish than markets currently expect – on both tapering and hiking rates. We agree with that assessment. Comments by RBA Governor Lowe earlier last month back our dovish belief: He stated that “The Board is committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target…This is unlikely to be until 2024 at the earliest”. Market expectations nevertheless remain much more hawkish – pointing to a first rate hike by mid 2022 and almost 70 basis points of hikes by 2024 (Chart 10). Chart 9...However Wage Growth Remains Muted ...However Wage Growth Remains Muted ...However Wage Growth Remains Muted Chart 10Market Expects A Hawkish RBA... Market Expects A Hawkish RBA Market Expects A Hawkish RBA   Chart 11...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve Chart 12Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target This means that the RBA will probably risk running the economy hot for a while. With total employment back to its pre-pandemic level and other employment indicators closely behind, inflationary pressures, sooner or later, will begin to mount. Higher growth prospects and inflation risks are being discounted further down the curve (Chart 11). The June CPI print is likely to reflect a transitory short-term base effect and the RBA is mostly going to see through that. In the meantime, we would watch other broad inflation indicators to gauge for price pressures. Broader measures such as the trimmed-mean inflation index or median inflation remain subdued at 1.1% and 1.3%, respectively. The 10-year breakeven rate currently stands at 2.1%, within the RBA’s range of 2%-3%, highlighting the market’s belief that long-term inflation remains well under control (Chart 12). Bottom Line: The RBA is likely to maintain its dovish stance for longer than the market expects. A return to sustainable levels of wage growth and inflation will remain the top objectives and it is unlikely that policy will be reversed before they are achieved. Our global fixed-income strategists laid out a checklist of what would make the RBA turn less dovish. So far, only 1 out of 5 items on their list (the recovery in private-sector demand) signals the need for a more hawkish stance. The remaining items signal no imminent pressure on the RBA to adjust policy (Table 1). The RBA is also wary of the currency appreciating if it took a more hawkish stance ahead of other central banks (e.g., the Fed) and is therefore likely to switch policy only after other central banks do so (Chart 13). Accordingly, investors should favor Australian government bonds within a global bond portfolio. Table 1RBA Checklist A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 13The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD   Q: Are There Signs Of Improvement In The Banking Sector? A: Headline indicators of the health of the Australian banking sector paint a picture of a well-capitalized, highly funded, and profitable industry. Return on equity (ROE) has averaged 12.1% over the past decade. Capital adequacy and Tier 1 capital ratios stand at 14.5% and 18.2%, respectively – much higher than at the start of the Global Financial Crisis (GFC). The ratio of non-performing loans remains low and Australian banks’ reliance on leverage has also decreased (Chart 14). Chart 14Banks Look Healthy... Banks Look Healthy... Banks Look Healthy... Chart 15...But Remain Exposed To The Housing Sector... ...But Remain Exposed To The Housing Sector ...But Remain Exposed To The Housing Sector However, these indicators mask a major underlying risk. Banks remain heavily exposed to the housing market, with housing loans as high as 62% of banks’ gross outstanding loans and 40% of total assets (Chart 15, panel 1). Over the past decade and a half, banks have lent an average of A$56 of housing-related loans for every A$100 in total loans (Chart 15, panel 2).   Chart 16...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down Chart 17Households Remain Heavily Indebted Households Remain Heavily Indebted Households Remain Heavily Indebted With interest rates falling over the past few decades, construction activity has boomed. Consequently, the demand for loans for new homes has been rising, leading home prices higher (Chart 16). This also meant that household debt levels have climbed and currently standing at a staggering 130% of GDP and 180% of disposable income (Chart 17).   So what does this mean for banks’ stock prices? The short answer is that absent a bursting of the bubble in house prices, banks should continue to fare well. Interestingly, the long-standing relationship between bond yields and banks’ relative stock price returns – one that works in other financial-heavy markets such as the euro area – did not hold in Australia, at least until recently. In fact, we find that, historically, Australian banks outperformed the broad market when bond yields were falling. This relationship changed post-GFC, most likely when inflation expectations became unanchored and trended lower – reflecting lower commodity prices (Chart 18). Bottom Line: Rising rates, reflecting better growth prospects and higher long-term inflation, should be a tailwind for bank stocks in the short term. Accommodative monetary policy will spur activity in the property market, propping up bank profits. This, however, puts banks at even greater risk when profitability starts to decline, NPLs rise and regulations tighten further. The latter risk is one we would highlight following RBA deputy governor Guy Debelle’s statement that monetary policy will not be used as a tool to curtail housing prices and that there are other tools to address that issue. Chart 18Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities   Q: How Does Chinese Policy Impact Australian Growth? A: China's role in global supply chains, as both a producer and consumer, has increased dramatically since the early 2000s. China’s demand for commodities generally and industrial metals in particular has grown over the past two decades from an average of 10% of total global demand to 50% for most metals (Chart 19). Australia stood to benefit, redirecting more and more of its metals’ production away from the rest of the world and towards China. For example, during the same period, the share of Australian iron ore exports to China increased fourfold (Chart 20). Chart 19China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... Chart 20...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades     However, this dynamic leaves the Australian economy very exposed to the Chinese business cycle – one that is heavily reliant on policymakers’ decisions on how much liquidity to inject into the economy. After strong credit and fiscal support throughout 2020, the Chinese authorities – wary of excessive leverage in the economy – have begun paring back stimulus which is likely to lead to weaker growth in the second half of the year and put downward pressure on metal demand (Chart 21). Chart 21Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Heightened political tensions between Australia and China have also played a role. China recently imposed restrictions, including additional tariffs and bans, on Australian imports such as beef, wine, coal, and other goods. Consequently, Australian exports to China slowed. However, the goods not imported by China were absorbed by other economies – Australian export growth did not fall that much. It is unlikely that a new commodity-heavy marginal buyer will emerge in the short-term to replace Chinese demand. The recent rise in commodity prices reflected a return to economic activity, as well as inflationary fears, and supply, shipping, and logistical backlogs. These will ease in the short term, weighing on both the AUD and Australian equities.   Q: Can The Shift To Renewable Energy Spur Future Australian Growth? A: The shift to renewable energy and electrification – particularly in the transport sector – will occur sooner rather than later. Some commodity-exporting countries stand to benefit, and Australia is likely to be one. We previously highlighted that modeling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency and recycling rates, and the rate of conversion to renewables. Chart 22The Shift To Renewables Will Require More Resources... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under The mechanics of the future demand/supply relationship hinge on the following: Demand will rise during this energy transition period – simply due to the fact that the new clean energy systems require more minerals (such as copper and zinc) than the current traditional hydrocarbon-fueled energy system (Chart 22, panel 1). Electric vehicles (EVs) require about four and a half times more of certain commodities – particularly copper, nickel, and graphite – than conventional vehicles do (Chart 22, panel 2). Supply limitations, on the other hand, are what might propel metal prices even higher and lead the world economy into a new commodities “supercycle”. A study by the Institute for Sustainable Futures has shown that, in the most positive energy transition scenarios, demand for some metals will exceed supply, in terms of both available resources and reserves (Table 2). Table 2...Which Are Likely To Be In Short Supply A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under For some of those metals, Australia is either among the top producers, or has the largest reserves. For example, Australia produces almost 45% and 12% of the world’s lithium and zinc, and has 22% and 27% of the world’s reserves. Looking at other metals, supply disruptions – particularly in economies where political, social, and environmental influences are an issue – might be the driver of further price rises. For example, Chile has the largest shares of global lithium reserves (~44%), and copper reserves (~23%), while South Africa has the largest share of global manganese reserves (~40%). Bottom Line: The transition to renewable energy is already underway and is likely to intensify. Forecast demand should outstrip supply and Australia stands to benefit given its large share of current production and/or reserves. How much will depend on the pace of renewable energy integration but miners are likely to be long-term winners.   Q: What Is The Outlook For The AUD? A: The Global Asset Allocation (GAA) service, in its latest Quarterly Outlook, turned negative on the AUD. The currency has historically had a high positive correlation with commodity prices and industrial metals prices, which in turn are very sensitive to Chinese demand (Chart 23). Given our outlook for metals in the short term (falling demand driven by slowing Chinese activity), we expect some weakening in the AUD over the coming 9-to-12 months (Chart 24). Chart 23The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... Chart 24...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity Additionally, short-term weakness in the economy, caused by further lockdowns as Delta-variant COVID cases rise, is a risk since it might reduce domestic demand. From a valuation perspective, the AUD is slightly below its fair value (Chart 25). However, this on its own does not compel us to remain positive on the currency. We also consider other indicators such as investor positioning – which has reached a decade high, according to Citibank’s FX Positioning Alert Indicator (PAIN) (Chart 26). This indicator suggests that active FX traders hold substantial long positions in the AUD against the USD. Historically, this indicator has provided contrarian signals, with extreme optimism (pessimism) providing useful short (long) signals. Chart 25The AUD Is Close To Fair Value The AUD Is Close To Fair Value The AUD Is Close To Fair Value Chart 26Investors Are Long The AUD Investors Are Long The AUD Investors Are Long The AUD Bottom Line: Short-term weakness in the economy and a reversal in metal prices warrant caution on the currency. While valuations do not signal overbought conditions, investor positioning (a contrarian indicator) does.   Q: How Should Equity Investors Be Positioned? A: Our recent Special Report on whether country or sector effects drive equity performance showed that sector composition was relatively important in Australia, given the large difference in sector weightings relative to the global benchmark. Our analysis showed that cumulative Australian sector performance over the past two decades detracted from overall returns (Chart 27). Given that framework, and the relationship between the Australian economy and industrial metals, we find that Australian equity performance relative to the US mirrors the performance of global metal and mining relative to global tech stocks (Chart 28). This underperformance makes sense: Commodity prices have been in a structural downtrend throughout the past decade. Chart 27Country Vs Sector Effect Country Vs Sector Effect Country Vs Sector Effect Chart 28Australia / US = Metals / Tech Australia / US = Metals / Tech Australia / US = Metals / Tech Therefore, given our view of the outlook for metals, we would not want to shun Australian equities. The Global Asset Allocation (GAA) service is currently neutral the Australian market within a global equity portfolio, and underweight the Materials sector over the next 12 months. We believe this positioning makes sense given the slowdown in the Chinese economy and the improbability that another country will emerge as the alternative marginal buyer of commodities. The longer-term outlook is more compelling however, as the shift to decarbonization, renewables, and alternative energy gets underway. Conclusions In the short term metals prices are likely to suffer on the back of weakening Chinese demand (with no immediate substitute as a marginal buyer) as well as fading inflationary fears and an easing of supply/logistical issues. Our analysis shows that sector composition is a larger driver of Australian equity relative performance than country composition. While Australian equities – dominated by Financials – would benefit from a moderate rise in global bond yields, yields will rise more slowly in Australia than in the US and the AUD is likely to weaken. Over the next 12 months, investors should remain neutral on Australian equities within a global equity portfolio. The RBA is likely to lag other central banks in tightening policy. Investors should therefore favor Australian government bonds over other developed economies such as the US and Canada.   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com