British Pound

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US A Growth Rotation Away From The US A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar US Dollar US Dollar Chart 5BUS Dollar US Dollar US Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Euro Euro Chart 6BEuro Euro Euro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Japanese Yen Japanese Yen Chart 7BJapanese Yen Japanese Yen Japanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound British Pound British Pound Chart 8BBritish Pound British Pound British Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Australian Dollar Australian Dollar Chart 9BAustralian Dollar Australian Dollar Australian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 10BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Canadian Dollar Canadian Dollar Chart 11BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Swiss Franc Swiss Franc Chart 12BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Norwegian Krone Norwegian Krone Chart 13BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Swedish Krona Swedish Krona Chart 14BSwedish Krona Swedish Krona Swedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights The most important question is whether the Fed will hike interest rates by more than what is currently discounted in markets, or less. More hikes will trigger a set of cascading reactions. US bond yields will initially jump, boosting the dollar. But this process could also undermine growth stocks, and the US equity market leadership. Equity portfolio flows have been more important in financing the US trade deficit, than Treasury purchases, since 2020. Hence, a reversal in these flows will undermine a key pillar of support for the dollar. On the flip side, less rate hikes will severely unwind higher interest rate expectations in the US vis-a-vis other developed markets, especially in the euro area and Japan. This means we could be witnessing a shift in the dollar, where upside is capped, and downside is substantial. Feature Chart 1The Dollar In 2021 The Dollar In 2021 The Dollar In 2021 The two most important drivers of the dollar over the last few months have been the spread between US interest rates and other developed markets, as well as the relative performance of US equities (Chart 1). Rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. The outperformance of the US equity market has also coincided with notable portfolio inflows into US equities in 2021. This cocktail of macro drivers has pinned the US dollar in a quandary. If rates rise substantially in the US, and that undermines the US equity market leadership, the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. The Dollar And The Equity Market The traditional relationship between the dollar and the equity market was negative for most of the first half of the pandemic. Monetary easing by the Federal Reserve stimulated global financial conditions setting the stage for an epic bull market. The correlation between the S&P 500 and the DXY index was a near perfect inverse correlation for much of 2020 (Chart 2). Chart 3US Equity Portfolio Inflows Have Been Substantial Since 2020 US Equity Portfolio Inflows Have Been Substantial Since 2020 US Equity Portfolio Inflows Have Been Substantial Since 2020 Chart 2The Dollar In ##br##2020 The Dollar In 2020 The Dollar In 2020 The big change in 2021 is that this correlation has shifted, as the Fed has pivoted on monetary policy. This means that investors have been betting on higher stock prices in the US, as well as higher interest rates. In short, portfolio flows into US equities have surged (Chart 3). For the long-duration US equity market, higher interest rates could push it to a tipping point, where it starts to underperform other developed market bourses. This will reverse these equity portfolio flows, hurting the dollar in the process. Profits, Interest Rates And The Dollar The key driver of equity markets is profits in the short run, with valuation starting to matter over the longer run. This in turn becomes the key driver of cross-border equity flows. These flows help dictate currency movements. For much of the previous decade, US profits did much better than overseas earnings. For this reason, the US equity market outperformed, pulling the dollar up, as foreign equity purchases accelerated (Chart 4). The post-pandemic era has seen inflation rising across the world, changing the paradigm for US profits. High inflation, and consequently, higher bond yields, have been synonymous with an underperformance of US profits (Chart 5). Banks profit from higher rates, as they benefit from rising net interest margins. Materials, energy, and industrial stocks, benefit from higher inflation via rising commodity prices that boost their pricing power. In a nutshell, rising inflation tends to be better for value stocks and cyclicals, sectors that are underrepresented in the US. This means portfolio flows into US equities, one of the key drivers of the capital account surplus, could be on the cusp of a substantial reversal. Chart 4The Dollar And Relative Profits The Dollar And Relative Profits The Dollar And Relative Profits Chart 5Bond Yields And Relative Profits Relative Profits And Bond Yields Relative Profits And Bond Yields Second, valuation in the US has become extended as interest rates have fallen. More importantly, US valuations have been more sensitive to changes in interest rates, compared to other developed markets (Chart 6). This is because the US stock market has become increasingly overweight long duration sectors, like technology and healthcare. Higher rates will undermine the valuation premium these sectors command. This will cause the US equity market to derate relative to other cyclical bourses. Chart 6Relative Multiples And Bond Yields Relative Multiples And Bond Yields Relative Multiples And Bond Yields The key point is that the US equity market has been the darling of the last decade, and leadership is at risk from higher rates, via a reset in both relative valuation and relative profits. So, while the US market could perform well in 2022, higher rates could undermine its relative performance to overseas bourses. This will curtail equity portfolio inflows, as capital tends to gravitate to markets with higher expected returns. The Dollar And Relative Interest Rates Over the long term, bond flows are the overarching driver of the currency market. Most market participants expect the Fed to be among the most hawkish in 2022. This is clear in the pricing of the Eurodollar versus Euribor December 2022 contract, or just the relative path of two-year US bond yields versus other markets. This in turn has helped drive speculative positioning in the US dollar towards record highs (Chart 7). Correspondingly, US Treasury inflows have accelerated in recent months, even though real interest rates have not risen that much (Chart 8). In level terms, the trade deficit (that hit a record low of -US$80bn in November) is being helped financed by renewed foreign interest in US Treasurys. Chart 8Interest Rates And Treasury Flows Interest Rates And Treasury Flows Interest Rates And Treasury Flows Chart 7Record Dollar Speculative Positions Record Dollar Speculative Positions Record Dollar Speculative Positions We see two major contradictions in the pricing of US interest rates, relative to other developed markets. First, rising inflation is a global phenomenon and not specific to the US. If inflation proves sticky, other central banks will turn a tad more hawkish to defend their policy mandates. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. This will unwind speculative long positions in the dollar. It will also slow portfolio inflows into US Treasuries. Second, the reality is that outside the ECB and the BoJ, most other developed market central banks have already tightened monetary policy ahead of the Fed. The ability of any central bank to tighten policy will depend on the health of the labor market, and the potential for a wage inflation spiral. One data point that has caught our attention is the participation rate across G10 economies - it is notable that the US has one of the lowest participation rates (Chart 9A). Given that many countries have seen their participation rate recover to pre-pandemic levels, it suggests upside in the US rate. This will be especially the case if fiscal stimulus, which could wane, has been a key reason why the US participation rate has stayed low. In a nutshell, the low participation rate in the US could be a reason the Fed lags market expectations for aggressive rate increases this year. On the flip side, a higher participation rate in places like Canada, Norway, and Australia, could allow their central banks to normalize policy faster than the market expects. There has been a loose correlation between relative changes in the participation rate, and relative changes in inflation across G10 economies (Chart 9B).  Chart 9BThe US Relative Participation Rate And Relative Inflation The US Relative Participation Rate And Relative Inflation The US Relative Participation Rate And Relative Inflation Chart 9AUS Labor Force Participation Is Low, But Improving US Labor Force Participation Is Low, But Improving US Labor Force Participation Is Low, But Improving Finally, relative monetary policy tends to be driven by relative growth. US growth remains robust but has been rolling over relative to other developed markets (Chart 10). This is occurring at a time when China is easing monetary policy, which tends to buffet non-US growth. Higher non-US growth could also tip the bond and currency market narrative that the Fed will tighten much faster than other G10 central banks. Chart 10Non-US Growth Is Improving, Relative To US Growth Non-US GROWTH Is Improving, Relative To US Growth Non-US GROWTH Is Improving, Relative To US Growth Conclusion The above analysis suggests we could be entering a paradigm shift in the dollar, where any response by the Fed could eventually trigger the same outcome. Higher rates than the market expects will initially boost the US dollar. But this process will also undermine the US equity market leadership, reversing substantial portfolio inflows in recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US vis-a-vis other developed markets. Our concluding thoughts from our 2022 outlook, which are consistent with our views herein, were as follows: The DXY could touch 98 in the near term but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a currency basket of oil producers versus consumers. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar. The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights In this week’s report we update our Chart Pack, updating familiar charts that underscore our strategic themes and cyclical/tactical views. Social unrest in Kazakhstan points to two of our strategic themes: great power struggle and populism/nationalism. A sneak preview of our Black Swan risks for the year: Iran crisis, Russian aggression, and a massive cyber attack. Recent market moves reinforce the BCA House View that investors will rotate out of US growth stocks and into global cyclicals and value plays.  We are sticking with our current tactical and cyclical views and trades. Feature Since releasing our key views for 2022, bond yields have surged, tech shares have sold off, and social unrest has erupted in Central Asia. These developments have both structural and cyclical drivers and are broadly supportive of our investment strategy. First, a brief word about Kazakhstan. The surge in unrest this week is a new and urgent example of one of our strategic themes: populism and nationalism. Long-accumulating Kazakh nationalism is blowing up and forcing the autocratic regime to complete an unfinished political leadership transition that began three years ago. Russia is now forced to intervene militarily to maintain stability in this important satellite state. If instability is prolonged, Russia will be weakened in its high-stakes standoff against the United States and the West over Ukraine. China’s interest in Kazakhstan is also threatened by the change in political orientation there. We will provide a full report on this topic soon but for now the investment implication is to stay short Russian equities. In the rest of this report we offer our newly revised chart book for investors to consider as they gird for a year that promises to be anything but dull. The purpose of the chart book is to update a succinct series of charts that underpin our key themes and views. Many of these charts will be familiar to regular readers but here they are updated with some notable points highlighted in the text. A Waning Pandemic And Global Growth Falling To Trend The Omicron variant of COVID-19 is causing a surge of new cases and hospitalizations around the world, which will weigh on economic activity in the first quarter. However, this variant does not appear to be a game changer. While it is highly contagious, not as many people who go to the hospital end up in the intensive care unit (Chart 1). Chart 1 China is in a difficult predicament that will continue to constrict the global supply side of the economy. Chinese authorities maintain a “zero COVID” policy that emphasizes draconian social restrictions to suppress COVID cases and deaths to minimal levels (Chart 2A). Chart 2 ​​​​​ Chart 2 But Chinese-made vaccines are not as effective as western alternatives, particularly against Omicron, as discussed in our flagship Bank Credit Analyst. Hence China cannot open its economy without risking a disastrous wave of infections. When China shuts down activity, as at the Yantian port last spring, the rest of the world suffers higher costs for goods (Chart 2B). Chart 3Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global economic growth is decelerating from the peaks of the extreme rebound (Chart 3). The historic fiscal stimulus of 2020 (Chart 4A) is giving way to negative fiscal thrust, or a decline in budget deficits, that will take away from growth (Chart 4B). Chart 4 Chart 4 Chart 5Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Yet a recession is not the likeliest scenario since growth is expected to stabilize given the resumption of activity across the world due to an improved ability to live with the virus. The Federal Reserve is considering hiking interest rates faster than the market had expected given that the unemployment rate is collapsing and core inflation is surging. The persistence of the pandemic’s supply disruptions adds to concerns. At the same time, a wage-price spiral is not yet taking shape, as our bond strategist Ryan Swift shows. Productivity is growing faster than real wages and long-term inflation expectations remain within reasonable ranges, at least for now (Chart 5). Three Strategic Themes In our annual outlook (“2022 Key Views: The Gathering Storm”)  we revised our long-term mega themes: 1. Great Power Struggle The US’s relative decline as a share of global geopolitical power, despite a brief respite last year, is indicated in Charts 6-8. Chart 6 Chart 7 ​​​​​ Chart 7 ​​​​​ Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) 2. Hypo-Globalization An ongoing globalization process, yet one that falls short of potential, is shown in Charts 9-10. A tentative improvement in our multi-century globalization chart is misleading – it is due to lack of data reporting by several countries, which artificially suppresses the denominator.  Chart 9Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 10AFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization While trade sharply rebounded from the pandemic, the global policy setting is now averse to ever-deeper dependency on international trade. Chart 10BFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization ​​​​​ 3. Populism and Nationalism The post-pandemic cycle will see these structural trends reaffirmed. Charts 11-12 shows a rising Misery Index, or sum of unemployment and inflation, a source of political turmoil that will both reflect and feed these trends. Chart 11Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism ​​​​​​ Chart 12EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 ​​​​​ Chart 12 highlights major markets that have local or nationwide elections in 2022-23, where policy fluctuations are already occurring with various investment implications. We are tactically bullish on South Korea and Brazil, strategically but not tactically bullish on India, and bearish on Turkey. Russia’s domestic sociopolitical problems are not all that different from Kazakhstan’s and its response may be outwardly aggressive, so we are bearish. Three Key Views For 2022 Our annual outlook also outlined three key views for this year: 1. China’s Reversion To Autocracy The government will ease policy to secure the economic recovery so that President Xi Jinping can clinch his personal rule for at a critical Communist Party personnel reshuffle this fall (Chart 13). Chart 13China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy A stabilization of Chinese demand in 2022 will be positive for commodities, cyclical equity sectors, and emerging markets. Chart 14 ​​​​​​ Chart 14 Policy easing will not lead to a sustainable rally in Chinese equities, as internal and external political risks remain high (Charts 14A & 14B). A “fourth Taiwan Strait Crisis”  is likely in the short run while a military conflict is not unlikely over the long run. ​​​​​​​​​​​​​​2. America’s Policy Insularity The Biden administration is focused on domestic legislation and the midterm elections, due November 8, 2022. Biden’s approval rating has deteriorated further, putting the Democrats in line for a loss of around 40 seats in the House and four seats in the Senate, judging by historic patterns (Chart 15). But our sense is that the Senate is still in play – Democrats probably will not lose four Senate seats – but they are likely to lose control of both chambers as things stand. Chart 15 However, the Democrats still have a subjective 65% chance of passing a partisan budget reconciliation bill, which would be a badly needed victory. The “Build Back Better” plan would include a minimum corporate tax and various social programs. Another round of fiscal reflation would reinforce the Federal Reserve’s less dovish pivot. Chart 16US Still At Peak Polarization US Still At Peak Polarization US Still At Peak Polarization Polarization will remain at historic peaks leading up to the election, as the Democrats will need “wedge issues” to drive enthusiasm among their popular base in the face of Republican enthusiasm. For decades polarization has correlated with falling Treasury yields and US tech sector equity outperformance (Chart 16). Midterm election years tend to see flat equity performance and falling yields, albeit with yields higher when a single party controls government, as is the case this year. 3. Petro-State Leverage Globally, commodity markets continue to tighten on the supply side. Our Commodity & Energy Strategist Bob Ryan outlines the situation admirably: The supply side is tightening in oil markets, where OPEC 2.0 producers have been unable to restore output under their agreement to return 400,000 barrels per day each month since August 2021. It is true in base metals, where the energy crisis in Europe and Asia are constricting supplies, particularly in copper. And it is true in agricultural commodities, where high natural gas prices are driving fertilizer prices higher, which will push food prices up this year. Demand for these commodities will increase as Omicron becomes the dominant COVID-19 strain, keeping consumption above production, particularly in oil. These are long-term trends. Oil and natural gas markets will probably remain tight throughout the decade, as will base metal markets. This is going to put enormous stress on the global energy transition to renewable energy over the next 10 years. The ascendance of left-of-center political parties in critical base-metal exporting states, and rising ESG initiatives, will increase costs for energy and metals producers; and global climate activism in boardrooms and courtrooms will push costs higher as well. Higher prices will be necessary to recover these cost increases. In this context, energy producers gain geopolitical leverage. Their treasuries become flush with cash and they see an opportunity to pursue foreign policy objectives. Conflicts involving oil producers are more likely when oil prices are swinging up (Chart 17). Chart 17 This trend is on display in Russia’s dispute with the West, where Europe is struggling with a surge in natural gas prices due to Russian supply constraints that weaken its resolve in the showdown over Ukraine (Chart 18, top panel). Chart 18Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem ​​​​​ Yet even in the energy-independent US, the Biden administration is wary of pursuing policies against Russia or Iran that would ignite a bigger spike in prices at the pump during an election year (Chart 18, bottom panel). Biden will have to attend to foreign policy this year but will be defensive. Petro-states are not immune to domestic problems, including social unrest. Many of them are poor, unequal, misgoverned, and suffering from inflation. Iran is a prime example. Yet Iran has not collapsed under sanctions so far, the world is recovering, and Tehran has the advantage in its negotiations with the US because it can stage attacks across the Middle East, including the Persian Gulf and Strait of Hormuz. Military incidents could drive oil prices into politically punitive territory. Three Black Swans For 2022 This brings us to three “Black Swans” or low-probability, high-impact events for 2022. We will publish our regular annual report on this year’s black swans soon. For now we offer a sneak preview: 1. Iran Crisis In Middle East The fear of being abandoned by the US has kept Israel from acting unilaterally so far (Chart 19A). Chart 19 ​​​​​​ Chart 19 ​​​​ But an attack is not impossible if Iran reaches “breakout” levels of highly enriched uranium – and the global impact of an attack could be catastrophic (Chart 19B). The news media have been conspicuously quiet about Iran. Taken together, this scenario is pretty much the definition of a black swan. 2. Russian Aggression Abroad There is a 50% chance that Russia will stage a limited re-invasion of Ukraine to secure its control of territory in the east or along the Black Sea coast. Chart 20Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Within this risk, there is a small chance (less than 5%) that Russia would invade all of Ukraine. We do not expect this and neither do other analysts. The total conquest of Ukraine is unlikely when Russia’s domestic conditions are weak and it faces so much unrest in other parts of its sphere of influence (including Belarus and Kazakhstan). As we go to press, Russia is staging a military intervention in Kazakhstan, which could expand. Kazakhstan could create a way for Russia to avoid its self-induced pressure to take military action against Ukraine. But most likely Russia and Kazakhstan will quell the unrest, enabling Russia to sustain the threat of a partial re-invasion of Ukraine. Putin’s low approval rating often triggers new foreign adventures and financial markets are pricing higher risks (Chart 20). 3. Massive Cyber Attack Amid the pandemic and inflation surge, investors have forgotten about the huge risks facing businesses and individuals from their extreme dependency on remote work and digital services. A cyber war is also raging behind the scenes. So far it has not spilled into the physical realm. Yet Russia-based ransomware attacks in 2021 showed that vital US infrastructure is vulnerable. Cyber stocks have topped out amid the recent tech selloff (Chart 21A). But the global average cost of data breaches is skyrocketing. Governments are devoting more resources to network security and cyber-security (Chart 21B), which should be positive for earnings. Chart 21ABlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Chart 21BBlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Investment Takeaways The revised Geopolitical Risk Index does not show as pronounced of an uptrend as the version published last year but it is still higher than in the late 1990s (Chart 22). Our reading of all available evidence points to rising geopolitical risk – at least until the current challenge to US global supremacy leads to a new equilibrium. Chart 22 Global policy uncertainty is also rising on a secular basis and maintaining its correlation with the trade-weighted dollar, which has rebounded despite the global growth recovery and rise in inflation (Chart 23). We remain neutral on the dollar. Chart 23A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty Gold has fallen from its peaks during the onset of the pandemic and real rates suggest it will fall further. But we hold it as a hedge against geopolitical risk as well as inflation (Chart 24). Chart 24Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation The evidence is inconclusive about whether global investors will rotate away from US assets this year. The US share of global equity capitalization is stretched. Long-dated Treasuries will eventually reflect higher inflation expectations (Chart 25). Chart 25No Substitute For The USA Yet No Substitute For The USA Yet No Substitute For The USA Yet ​​​​​ Chart 26Waiting For Rotation Waiting For Rotation Waiting For Rotation ​​​​​ US equity outperformance continues unabated and emerging market equities are still underperforming their developed peers (Chart 26). Cyclically investors should take the opposite side of these trends but not tactically. The renminbi is tentatively peaking against both the dollar and euro. As expected, China’s policymakers are shifting toward preserving economic stability (Chart 27). Stabilization may require a weaker renminbi, though producer price inflation is also a factor for the People’s Bank to consider. Chart 27Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Taiwanese stocks continue to outperform Korean stocks (to our chagrin) but they have not broken above previous peaks relative to global equities. Nor has the Taiwanese dollar broken above previous peaks versus the greenback (Chart 28). So far Taiwan has avoided the fate of semiconductor stocks, which have sold off. This situation presents a buying opportunity for semi stocks but we remain short Taiwan as a bourse because it is central to US-China strategic conflict. Chart 28Strategically Short Taiwan Strategically Short Taiwan Strategically Short Taiwan ​​​​​​ Chart 29Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe ​​​​​​ Chart 30Safe Havens Look Attractive Safe Havens Look Attractive Safe Havens Look Attractive Russia and eastern European assets continue to underperform developed market peers as geopolitical risks mount across the former Soviet Union (Chart 29). Russia’s negotiations with the US, NATO, and the EU in January will help us to gauge whether tensions will break out to new highs. Assuming Russia succeeds in quashing Kazakh unrest, it will be necessary for the US to offer concessions to Russia to prevent the Ukraine showdown from worsening Europe’s energy crisis. Safe havens caught a bid in early 2021 and have not yet broken down. Our geopolitical views support building up safe-haven positions (Chart 30). Presumably one should favor global cyclical equities as the pandemic wanes and global growth stabilizes. But cyclicals are struggling to outperform defensives (Chart 31A). Chart 31AFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ Chart 31BFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ ​​​​​​​China’s policy easing is positive in this regard, although the new wave of fiscal-and-credit support is only just beginning and financial markets will remain skeptical until the dovish policy pivot is borne out in hard data (Chart 31B). Global value stocks have ticked up again versus growth stocks, suggesting that the choppy process of bottom formation continues (Charts 32A & 32B). Chart 32AValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​​ Chart 32BValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights US economic data remains robust, but economic surprises are rolling over relative to other G10 countries. Meanwhile, the Fed is turning a tad more hawkish, which is positive for the greenback in the short term but could hurt growth over a cyclical horizon.  A hawkish Fed and dovish PBoC could set the stage for an economic recovery outside the US. We are not fighting the Fed (dollar bullish in the near term), and most of our trades are at the crosses. These include long EUR/GBP, long AUD/NZD and long CHF/NZD. We also have a speculative long on AUD/USD. We were stopped out of our short USD/JPY trade at break even and will look to reinstate at more attractive levels. Feature Chart 1 The dollar was the best performing G10 currency last year (Chart 1), which begs the question if this outperformance will be sustained in 2022. In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Most recently, PMI releases across the developed world have remained robust but are peaking (Chart 2). The key question is whether the slowdown proves genuine, and if so, whether the US can maintain economic leadership versus the rest of the G10. Chart 2AGlobal PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Chart 2BGlobal PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US The next key question is what central banks do about inflation. It is becoming clearer that rising prices are not a US-centric phenomenon but a global problem (Chart 3). Our bias is that central banks cannot meaningfully diverge on the inflation front. This will create trading opportunities. Chart 3AInflation Is A Global Problem Inflation Is A Global Problem Inflation Is A Global Problem Chart 3BInflation Is A Global Problem Inflation Is A Global Problem Inflation Is A Global Problem Over the next few pages, we look at the latest data releases and implications for currency strategy. US Dollar: Strong Now, Weaker Later? The dollar DXY index fell 0.4% in December and is up 0.5% year to date. A growth rotation from the US to other economies continues, even though US economic data over the last month remains rather robust. The latest release of the ISM manufacturing index remained strong at 58.7 for December, but this has rolled over from 61.1 in the previous month. More importantly, the prices paid index fell from 82.4 to 68.2. This suggests inflationary pressures are coming in, which could assuage tightening pressure on the Federal Reserve.  In other data, the trade deficit continues to widen, hitting a record -$97.8bn in November. Durable goods orders for November rose 2.5%, the biggest increase in six months. The consumer confidence index from the Conference Board has also rebounded, rising to 115.8 in December. Home prices are also rising, with an increase of almost 20% year on year in October. This suggests monetary conditions in the US remain very easy, relative to underlying demand. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. The Fed minutes this week highlighted a preference for a faster pace of policy normalization, in the face of a tightening labor market and persistent inflationary pressures. This put the US dollar in a quandary, relative to other developed market currencies. If the US tightens monetary policy, while China eases, it strengthens the dollar in the near term, but tightens US financial conditions that have been the bedrock of US demand. This will suggest peak US demand in the coming months, and a bottoming in demand for countries that are more sensitive to Chinese monetary conditions. Chart 4AUS Dollar US Dollar US Dollar Chart 4BUS Dollar US Dollar US Dollar The Euro: All Bets On China? The euro was up 0.4% in December. Year-to-date, the euro is down 0.5%. Inflation continues to rise in the eurozone, which begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. PPI came out at 23.7% year-on-year, the highest in several decades. Core consumer price index (CPI) in the eurozone is at 4.9%, a whisker below US levels. Economic data remain resilient in the euro area, despite surging Covid-19 cases. The ZEW expectations survey rose to 26.8 in December from 25.9. The trade balance remains in a healthy surplus (though rolling over). In a nutshell, economic surprises in the eurozone have been outpacing those in the US over the last month. The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their forecasts, inflation is headed below 2% by the end of 2022. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. In the near term, we expect a policy convergence between the ECB and the BoE. As such, we are long EUR/GBP on this basis. Over the longer term, we expect the ECB to lag the Fed, and thus we will fade any persistent strength in the euro. Chart 5AEuro Euro Euro Chart 5BEuro Euro Euro The Japanese Yen: The Most Hated Currency The Japanese yen was down 2% in December. It is also down 0.6% year-to-date. Overall, the yen was the worst performing G10 currency in 2021. Good news out of Japan continues to be underappreciated, while bad news is well discounted. Industrial production rose 5.4% in November, from a contraction the previous month, and the Jinbun Bank manufacturing PMI edged higher in December to 54.3. Retail sales are inflecting higher, and the national CPI has bottomed, easing pressure on the Bank of Japan to remain ultra-accommodative. The bull case for the yen remains intact. First, as we have witnessed recently, it will perform well in a market reset, given it is the most shorted G10 currency. Second, and related, the yen tends to do well with rising volatility, which we should expect in the coming months. Third, Covid-19 infections in Japan remain low, meaning should global cases rollover, Japan could be quicker in jumpstarting an economic recovery. Finally, an equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan, will benefit the yen via the portfolio channel. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models. We were long the yen and stopped out at break even (114.40). We will look to re-enter this trade at more attractive levels. Chart 6AJapanese Yen Japanese Yen Japanese Yen Chart 6BJapanese Yen Japanese Yen Japanese Yen British Pound: Near-Term Volatility The pound was up 1.9% in December. Year-to-date, cable is flat. UK data continues to moderate from high levels, similar to the picture in the US. Covid-19 infections continue to surge, but the December manufacturing PMI remains resilient at 57.9. Retail sales and house prices are also robust, and the latest CPI print for November, at 5.1%, justifies the interest rate hike by the Bank of England last month. The near-term path for the pound will be dictated by portfolio flows, and the ability of the BoE to deliver aggressive rate hikes already priced in the market. With the UK running a basic balance deficit, a dry up in foreign capital could hurt the pound. This will also be the case if the BoE does not deliver as many hikes as is discounted by markets. A rollover in energy costs (electricity prices are collapsing), and potentially, inflation could be catalyst. The post-Brexit environment also remains quite volatile.  This short-term hiccup underpins our long EUR/GBP call. Longer term, incoming data continues to strengthen the case for the BoE to tighten policy. At 4.2%, the unemployment rate is at NAIRU. Wages are also inflecting higher. As such, the pound should outperform over the longer-term, as the BoE continues to normalize policy. Chart 7ABritish Pound British Pound British Pound Chart 7BBritish Pound British Pound British Pound Australian Dollar: Top Pick For 2022 The Australian dollar was up 2.2% in December. Year-to-date, the Aussie is down 1.4%. Covid-19 continues to ravage Australia, prompting the government to adopt measures such as threatening to deport superstar athletes who refuse to be vaccinated. Combined with the zero-Covid policy in China (Australia’s biggest export partner), the economic outlook remains grim in the near term. In our view, such pessimism opens a window to be cautiously long AUD. First, speculators are very short the currency. Second, low interest rates are reintroducing froth in the property market that the authorities have fought hard to keep a lid on. Home prices in Sydney and Melbourne are rising close to 20% year-on-year. Most inflation gauges are also above the midpoint of the RBA’s target. Our playbook is as follows: China eases policy, allowing Australian exports to remain strong. This will allow the RBA to roll back its dovish rhetoric, relative to other central banks. This will also trigger a terms of trade recovery and interest rate support for the AUD. We are cautiously long AUD at 70 cents, and recommend investors stick with this position. Chart 8AAustralian Dollar Australian Dollar Australian Dollar Chart 8BAustralia Dollar Australia Dollar Australia Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar was up 0.25% in December, while down 1.1% year to date. The Covid-19 situation is much better in New Zealand, compared to its antipodean neighbor, but recent economic developments still have a stagflationary undertone. Headline CPI and house prices are rising at the fastest pace in decades, but wage growth remains very muted. With the RBNZ that now has house price considerations in its mandate, the risk is that further rate hikes hamper the recovery. Data wise, the trade balance continues to print a deficit as domestic demand in China remains tepid. New Zealand currently has the highest G10 10-year government bond yield, suggesting marginally tighter financial conditions. Meanwhile, portfolio flows into New Zealand have turned negative in recent quarters, especially driven by defensive equity outflows. Overall, the kiwi will benefit from a recovery in China but less so than the AUD, which is much shorted and has a better terms of trade picture. As such we are long AUD/NZD. Chart 9ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 9BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: Next Up After AUD? The CAD was up 1.4% in December. Year to date, the loonie is down 0.7%. The key driver of the CAD in 2022 remains the outlook for monetary policy, and the path of energy prices. We are optimistic on both fronts. On monetary policy, CPI inflation remains above the central bank’s target, house prices are rising briskly, and the trade balance continues to improve meaningfully. This provides fertile ground for tighter monetary settings. Employment in Canada is already above pre-pandemic levels and has now settled towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs (27,500 in December), is in line with trend. The unemployment rate continues to drop, hitting 6.0%. Oil prices also remain well bid, as outages in Libya offset planned production increases by OPEC. Should Omicron also fall to the wayside, travel resumption will bring back a meaningful source of demand. Net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. We are buyers of CAD over a 12–18-month horizon. Chart 10ACanadian Dollar Canadian Dollar Canadian Dollar Chart 10BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Line Of Defense The Swiss franc was up 0.8% in December and has fallen by 0.9% year to date. The Swiss economy continues to fare well amidst surging Covid-19 infections. Meanwhile, as a defensive currency, the franc has benefitted from the rise in volatility, especially compared to other currencies like the New Zealand dollar over the course of 2021 (we are long CHF/NZD). Economic wise, the unemployment rate has dropped to 2.5%, inflation is rising briskly, and house prices remain very resilient. This is lessening the need for the central bank to maintain ultra-accommodative settings. It is also interesting that the Swiss franc is well shorted by speculators engaging in various carry trades. Our baseline is that the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. That said, this is well baked in the consensus suggesting any risk-off event or pricing of less monetary accommodation in other markets will help the franc. One area of opportunity is being long EUR/CHF, where the market has priced a very dovish ECB, even relative to the SNB. We are long this cross (which could suffer in the short term) but should rise longer term.  Chart 11ASwiss Franc Swiss Franc Swiss Franc Chart 11BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: A Beta Play On A Lower Dollar The Norwegian krone was up 2.7% in December and is down 0.9% year to date. Norway was a developed market beacon of how to handle the pandemic until the more contagious Omicron variant started to ravage the economy. The latest data prints suggest core CPI is falling and house price appreciation is rolling over. Headline inflation remains strong, and the latest retail sales release shows 1% growth month on month for November suggesting some resilience amidst the pandemic. The Norges Bank has been the most orthodox in the G10, raising interest rates and promising to continue doing so in the coming quarters. Should Omicron prove transient and oil prices stay resilient, this will be a “carte blanche” for the Norges bank to keep normalizing policy.  Norway’s trade balance and terms of trade remain robust. Meanwhile, portfolio investment in some unloved sectors in Norway could provide underlying support for the NOK. We are buyers of the NOK on weakness. Chart 12ANorwegian Krone Norwegian Krone Norwegian Krone Chart 12BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: A Play On China The SEK was up 0.3% in December and is down 1% year to date. The performance of the Swedish economy continues to strengthen the case for the Riksbank to tighten monetary policy. In recent data, the trade balance remains in a surplus as of November, household lending is rising 6.6% year on year (November), retail sales remain robust, and PPI is inflecting higher. Manufacturing confidence also improved in December, along with improvement in labor market conditions.  The Riksbank will remain data dependent, but it has already ended QE. It remains one of the most dovish G10 central banks and is slated to keep its policy rate flat at 0% at least until 2024. This could change if inflationary pressures remain persistent. A bounce in Chinese demand could be the catalyst that triggers this change.  We have no open positions now in SEK, but will look to go short USD/SEK and EUR/SEK should more evidence of a Swedish recovery materialize. Chart 13ASwedish Krona Swedish Krona Swedish Krona Chart 13BSwedish Krona Swedish Krona Swedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights The last two years have taught us to live with Covid-19. This means global growth will remain strong in 2022. That is not reflected in a strong dollar. The RMB will be a key arbiter between a bullish and bearish dollar view. This is because a weak RMB will be deflationary for many commodity currencies, especially if it reflects weak Chinese demand. Inflation in the US will remain stronger than in other countries. The key question is what the Federal Reserve does next year. In our view, they will stay patient which will keep real interest rates in the US very low. Upside in the DXY is nearing exhaustion according to most of our technical indicators. We upgraded our near-term target to 98. Over a longer horizon, we believe the DXY will break below 90, towards 85 in the next 12-18 months. A key theme for 2022 will be central bank convergence. Either inflation proves sticky and dovish central banks turn a tad more hawkish, or inflation subsides and aggressive rate hikes priced in some G10 OIS curves are revised a tad lower. The path for bond yields will naturally be critical. Lower bond yields will initially favor defensive currencies such as the DXY, CHF and JPY. This is appropriate positioning in the near-term. Further out in 2022, as bond yields rise, the Scandinavian currencies will be winners. Portfolio flows into US equities have been a key driver of the dollar rally. This has been because of the outperformance of technology. Should this change, equity flows could switch from friend to foe for the dollar. A green technology revolution is underway and this will benefit the currencies of countries that will supply these raw materials. The AUD could be a star in 2022 and beyond. The rise in cryptocurrencies will continue to face a natural gravitational pull from policy makers.    Gold and silver will rise in 2022, but silver will outperform gold. Feature 2022 has spooky echoes of 2020. In December 2019, we were optimistic about the global growth outlook, positive on risk assets, and bearish the US dollar. That view was torpedoed in March 2020, when it became widely apparent that COVID-19 was a truly global epidemic. More specifically, the dollar DXY index (a proxy for safe-haven demand) rose to a high of 103. US Treasury yields fell to a low of 0.5%. Chart 1Covid-19 And The Dollar Covid-19 And The Dollar Covid-19 And The Dollar Today, the DXY index is sitting at 96, exactly the midpoint of the March 2020 highs and the January 2021 lows. Once again, the dollar is discounting that the new Omicron strain will be malignant – worse than the Delta variant, but not as catastrophic as the original outbreak (Chart 1). Going into 2022, we are cautiously optimistic. First, we have two years of data on the virus and are learning to live with it. This suggests the panic of March 2020 will not be repeated. Second, policymakers are likely to stay very accommodative in the face of another exogenous shock. This will especially be the case for the Fed. Our near-term target for the DXY index is 98, given that the macro landscape remains fraught with risks. This is a speculative level based on exhaustion from our technical indicators (the dollar is overbought) and valuation models (the dollar is expensive). Beyond this level, if our scenario analysis plays out as expected, we believe the DXY index will break below 90 in 2022. Omicron And The Global Growth Picture Chart 2Global Growth And The Dollar Global Growth And The Dollar Global Growth And The Dollar Our golden rule for trading the dollar is simple – sell the dollar if global growth will remain robust, and US growth will underperform its G10 counterparts. Historically, this rule has worked like clockwork. Using Bloomberg consensus growth estimates for 2022, US growth is slated to stay strong, but give way to other economies (Chart 2).  News on the Omicron variant continues to be fluid. As we go to press, Pfizer suggests a third booster dose of its vaccine results in a 25-fold increase in the antibodies that attack the virus. Additionally, a new vaccine to combat the Omicron variant will be available by March. If this proves accurate, it suggests the world population essentially has protection against this new strain. The good news is that vaccinations are ramping up around the world, especially in emerging markets. Countries like the US and the UK were the first countries to see a majority of their population vaccinated. Now many developed and emerging market countries have a higher share of their population vaccinated compared to the US (Chart 3). Chart 3ARising Vaccinations Outside The US Rising Vaccinations Outside The US Rising Vaccinations Outside The US Chart 3BRising Vaccinations Outside The US Rising Vaccinations Outside The US Rising Vaccinations Outside The US This has resulted in a subtle shift – growth estimates for 2022 are increasingly favoring other countries relative to the US (Chart 4). Let us consider the case of Japan - just in June this year, ahead of the Olympics, only 25% of the population was vaccinated. Today, Japan has vaccinated 77% of its population and new daily infections are near record lows. While Omicron is a viable risk, the starting point for Japan is very encouraging and should open a window for a recovery in pent-up demand and a pickup in animal spirits. Chart 4ARising Growth Momentum Outside The US Rising Growth Momentum Outside The US Rising Growth Momentum Outside The US Chart I-4 This template could very much apply to other countries as well. This view is not embedded in the dollar, which continues to price in an outperformance of US growth (Chart 5). The Risks From A China Slowdown China sits at the epicenter of a bullish and bearish dollar view. If Chinese growth is bottoming, then the historical relationship between the credit impulse and pro-cyclical currencies will hold (Chart 6). This will benefit the EUR, the AUD, the CAD and even the SEK which that track the Chinese credit impulse in real time. As an expression of this view, we went long the AUD at 70 cents. Chart 5Economic Surprises Outside The US Economic Surprises Outside The Us Economic Surprises Outside The Us Chart 6Chinese Credit Demand And Currencies Chinese Credit Demand And Currencies Chinese Credit Demand And Currencies Just as global policy makers are calibrating the risk from the Omicron variant, the Chinese authorities are also acknowledging the risk of an avalanche from a property slowdown. They have already eased monetary policy on this basis. Specific to the dollar, a key arbiter of a bullish or bearish view will be the Chinese RMB. So far, markets have judiciously separated the risk, judging that the Chinese authorities can surgically diffuse the real estate market, without broad-based repercussions in other parts of the economy (such as the export sector). Equities and corporate credit prices have collapsed in specific segments of the Chinese market but the RMB remains strong (Chart 7). Correspondingly, inflows into China remain very robust, a testament to the fact that Chinese growth (while slowing) remains well above that of many other countries (Chart 8). Chart 7The RMB Has Diverged From The Carnage In China The RMB Has Diverged From The Carnage In China The RMB Has Diverged From The Carnage In China Chart 8Strong Portfolio Inflows Into China Strong Portfolio Inflows Into China Strong Portfolio Inflows Into China China contributed 20% to global GDP in 2021 and will likely contribute a bigger share in 2022, according to the IMF (Chart 9). This suggests that foreign direct investment in China will remain strong . This will occur at a time when the authorities could have diffused the risk from a property market slowdown. Chart I-9 The commodity-side of the equation will also be important to monitor, especially as it correlates strongly with developed-market commodity currencies. It is remarkable that despite the slowdown in Chinese real estate, commodity prices remain resilient (Chart 10). This has been due to adjustment on the supply side, as our colleagues in the Commodity & Energy Strategy team have been writing. Finally, China offers one of the best real rates in major economies. It also runs a current account surplus. This suggests there is natural demand and support for the RMB (Chart 11). A strong RMB limits how low developed-market commodity currencies can fall. Chart 10Commodity Prices Remain Well Bid Commodity Prices Remain Well Bid Commodity Prices Remain Well Bid Chart 11Real Interest Rates Favor The RMB Real Interest Rates Favour The RMB Real Interest Rates Favour The RMB Inflation And The Policy Response Output gaps are closing around the world as fiscal stimulus has helped plug the gap in aggregate demand. This suggests that while inflation has been boosted by idiosyncratic factors (supply bottlenecks) that could soon be resolved, rising aggregate demand will start to pose a serious problem to the inflation mandate of many central banks. Chart 12A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally As we wrote a few weeks ago, there have been consistencies and contradictions with the market response to higher inflation. The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year. Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent) (Chart 12). The reality is that outside the ECB and the BoJ, other central banks have actually been more proactive compared to the Federal Reserve. The Bank Of Canada has ended QE and will likely raise interest rates early next year, the Reserve Bank of New Zealand has ended QE and raised rates twice, and the Reserve Bank of Australia has already been tapering asset purchases. The Bank of England will also be ahead of the Fed in raising interest rates, according to our Global Fixed Income Strategy colleagues. This suggests that the pricing of a policy divergence between the Fed and other G10 central banks could be a miscalculation and a potential source of weakness for the dollar. Chart 13The US Is Generating Genuine Inflation The US Is Generating Genuine Inflation The US Is Generating Genuine Inflation Rising inflation is a global phenomenon and not specific to the US (Chart 13). So either inflation subsides and the Fed turns a tad more accommodative, or inflation proves sticky and other central banks turn a tad more hawkish to defend their policy mandates. We have two key short-term trades penned on this view – long EUR/GBP and long AUD/NZD. While the European Central Bank will lag the Bank of England (and the Fed) in raising interest rates, expectations for the path of policy are too hawkish in the UK, with 4 rate hikes priced in by the end of 2022. Similarly, hawkish expectations for the Reserve Bank of New Zealand are likely to be revised lower, relative to the Reserve Bank of Australia. As for the US, the Fed is likely to hike interest rates next year but real rates will remain very low relative to history (Chart 14A and 14B). Low real rates will curb the appeal of US Treasuries. Chart 14AReal Interest Rates In The US Are Very Negative Real Interest Rates In The US Are Very Negative Real Interest Rates In The US Are Very Negative Chart I-14 The Dollar And The Equity Market Chart 15The US Stock Market And The Dollar The US Stock Market And The Dollar The US Stock Market And The Dollar One of the biggest drivers of a strong dollar this year (aside from rising interest rate expectations), has been equity inflows. The greenback tends to do well when US bourses are outperforming their overseas peers (Chart 15). It is also the case that value tends to underperform growth in an environment where the dollar is rising. We discussed this topic in depth in our special report last summer. Flows tend to gravitate to capital markets with the highest expected returns. So if investors expect the pandemic winners (technology and healthcare) to keep driving the market in an Omicron setting, the US bourses that are overweight these sectors will do well. We will err on the other side of this trade for 2022. Part of that is based on our analysis of the global growth picture in the first section of this report. If growth rotates from the US to other economies, their bourses should do well as profits in these economies recover. Earnings revisions in the US have been sharply revised lower compared to other countries (Chart 16). This has usually led to a lower dollar eventually. In the case of the euro area, there has been a strong and consistent relationship between relative earnings revisions vis-à-vis the US, and the performance of the euro (Chart 17). Chart 16Earnings Revisions Are Moving Against US Companies Earnings Revisions Are Moving Against US Companies Earnings Revisions Are Moving Against US Companies Chart 17Earnings Revisions Are Moving In Favor Of Euro Area Companies Earnings Revisions Are Moving In Favor Of Euro Area Companies Earnings Revisions Are Moving In Favor Of Euro Area Companies In a nutshell, should profits in cyclical sectors recover on the back of rising bond yields, strong commodity prices and a tentative bottoming in the Chinese economy, value sectors that are heavily concentrated in countries with more cyclical currencies such as Australia, Norway, Sweden, and Canada, will benefit. Ditto for their currencies. The Outlook For Petrocurrencies Chart I-18 When the pandemic first hit in 2020, oil prices (specifically the Western Texas Intermediate blend) went negative. This drop pushed the Canadian dollar towards 68 cents and USD/NOK punched above 12. This time around, the drop in oil prices (20% from the peak for the Brent blend) has been more muted. We think this sanguine market reaction is more appropiate in our view for two key reasons. First, as our colleagues in the Commodity & Energy Stategy team have highlighted, investment in the resource sector, specifically oil and gas, has been anemic in recent years. In Canada, investment in the oil and gas sector has dropped 68% since 2014 at the same time as energy companies are becoming more and more compliant vis-à-vis climate change (Chart 18). Second, if we are right, and Omicron proves to be a red herring, then transportation demand (the biggest source of oil demand) will keep recovering. In terms of currencies, our preference is to be long a petrocurrency basket relative to oil consumers. As the US is the biggest oil producer in the world (Chart 19), being long petrocurriences versus the dollar has diverged from its historical positive relationship with oil prices. Chart 20 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with oil prices and has outperformed a traditional petrocurrency basket. Chart 19The US Is Now A Major Oil Producer The US Is Now A Major Oil Producer The US Is Now A Major Oil Producer Chart 20Hold A Basket Of Oil Consumers Versus Producers Hold A Basket Of Oil Consumers Versus Producers Hold A Basket Of Oil Consumers Versus Producers Technical And Valuation Indicators The dollar tends to be a momentum-driven currency. Past strength begets further strength. We modelled this when we published our FX Trading Model, which showed that a momentum strategy outperformed over time (Chart 21).  The problem with momentum is that it works until it does not. Net speculative long positions in the dollar are approaching levels that have historically signaled exhaustion (Chart 22). There is a dearth of dollar bears in today’s environment. That is positive from a contrarian standpoint. Meanwhile, our capitulation index (a measure of how overbought or oversold the dollar is) is approaching peak levels. Chart 21The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency Chart 22Long Dollar Is A Consensus Trade Long Dollar Is A Consensus Trade Long Dollar Is A Consensus Trade Valuation is another headwind for the dollar. According to all of our in-house models, the dollar is expensive. That is the case according to both our in-house curated PPP model (Chart 23) and a simple one based on headline consumer prices (Chart 24). Chart I-23 Chart 24The Dollar is Expensive The Dollar is Expensive The Dollar is Expensive     In a broader sense, we have built an attractiveness ranking for currencies (Chart 25). This ranks G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone and Swedish krona are especially attractive as 2022 plays. Chart I-25 More specifically, the Scandinavian currencies have been one of the hardest hit this year. The Norwegian krone will benefit from the reopening of economies, particularly through the rising terms-of-trade. The Swedish krona will benefit from a pickup in the industrial sector, and continued strength in global trade. The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. As we have highlighted in previous reports, valuation is a poor timing tool in the short term but over a longer-term horizon, currencies tend to revert towards fair value. Where Next For EUR/USD? Our bias is that the euro has bottomed. The ECB will lag the Fed in raising interest rates, but the spread between German bund yields and US Treasuries does not justify the current level of the euro. More importantly, if European growth recovers next year, this will sustain portfolio flows into the eurozone, which are cratering (Chart 26). Our 2022 target for EUR/USD is 1.25, a level that will unwind 10.6% of the undervaluation versus the dollar. Beyond valuation,s a few key factors support the euro: As a pioneer in green energy and a pro-cyclical currency, the euro will benefit from portfolio flows into renewable energy companies, as well as foreign direct investment. A close proxy for these flows are copper prices, that have positively diverged from the performance of the euro (Chart 27). Chart 26The Euro And Portfolio Flows The Euro And Portfolio Flows The Euro And Portfolio Flows Chart 27EUR/USD And Copper EUR/USD And Copper EUR/USD And Copper ​​​​​ Inflation in the euro area is lagging the US, but is undeniably strong. As such, while the ECB will lag the Fed in tightening monetary policy, the divergence in monetary policy will not widen. Earnings revisions are moving in favor of European companies, as we have shown earlier. Historically, this has put a floor under the euro. Safe-Haven Demand: Long JPY Safe-haven currencies will perform well in the near term. We are long the yen, which is the cheapest currency according to our models and also one of the most shorted. CHF will also do well in the near term, though as we have argued, will induce more intervention from the Swiss National Bank. Chart I-28 We are long both the yen and CHF/NZD as short-term trades, but our preference is for the yen. First, Japan has one of the highest real rates in the developed world. So, outflows from JGBs are going to be curtailed. Second, the DXY and USD/JPY have a strong positive correlation, and this places the yen in a very enviable position as the dollar weakens in 2022 (Chart 28). A Final Word On Gold, Silver, And Precious Metals Chart 29Hold Some Gold Hold Some Gold Hold Some Gold Along with our commodity strategists, we remain bullish precious metals. In our view, inflation could prove stickier than most investors expect. This will depress real rates and support precious metals. Within the precious metals sphere, we particularly like silver and platinum.  Almost every major economy now has negative real interest rates. Gold (and silver) have a long-standing relationship with negative interest rates (Chart 29). Central banks are also becoming net purchasers of gold, which is bullish for demand. The true precious metals winner in 2022 could be silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 30). Second, gold is very expensive compared to silver (Chart 31). In general, when gold tends to make new highs (as it did in 2020), silver tends to follow suit. This means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both gold and palladium prices. Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart 30Hold Some Silver Hold Some Silver Hold Some Silver Chart 31Stay Short The GSR Stay Short The GSR Stay Short The GSR Concluding Thoughts Our currency positions, as we enter 2022, are biased towards a lower dollar, but we also acknowledge that there are key risks to the view. Our recommendations are as follows: The DXY will could touch 98 in the near term, but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Chart 32Hold Some AUD Hold Some AUD Hold Some AUD Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a basket of oil producers versus consumers once volatility subsides. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar (Chart 32). The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com​​​​​​​ Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

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

Highlights We are reviewing our recommendations. We are also introducing recommendation tables to monitor these positions. Overall, our main recommendations have generated alpha and have a positive batting average. Feature The end of the month of August offers an opportunity to review the positions recommended in this publication. We introduce three tables corresponding to three investment horizons—tactical, cyclical, and structural—which summarize our main views. Each table is subdivided by asset class, namely equities, fixed income, and currencies. The tables can be found on page 12 and 13 and will be available at the end of future strategy reports. Tactical Recommendations Short Equity Leaders / Long Laggards This position is down 1.4% since inception. The idea behind this bet was that the easy money in the market had been made, and investors needed to become more discerning, although the big-picture economic backdrop continued to favor a pro-cyclical, pro-risk bias in a portfolio. To achieve this goal, we opted to buy cyclicals sectors that had lagged the broad market and to sell the ones that had already overtaken their pre-COVID highs, in the hope of creating a portfolio hedge. Practically, this meant buying sectors such as Industrials, Banks and Energy, while selling sectors such as Capital goods, Autos and Consumer services (Chart 1). This position has not worked out well as yields fell. Chart 1Leaders vs Laggards The Road So Far The Road So Far UK Mid-Cap And Small-Cap To Outperform This position is up 3.4% since inception. We initially favored the more domestically-oriented mid- and small-cap indices in the UK as a bet on the re-opening trade, following the lead taken by the UK in the global vaccination campaign. A faster re-opening would not only boost the ability of smaller domestic firms to generate cash flows, it would also elevate the pound, which would hurt the profit translation of the multinational dominating the UK large-cap indices. By mid-May, we opted to move small cap back to neutral, as the positive story was well discounted and we expected the GBP to correct, which would help large-cap stocks. Favor European Banks Relative To US Ones This position is up 4.1% since inception. It is mainly a value trade. The European economy has lagged behind that of the US, and European yields remain well below US ones. As a result, European financials have greatly underperformed their US counterparts. However, this performance differential has left European banks trading at an enormous discount relative to their US peers. Hence, as continental European economies were catching up to the US on the vaccination front, we expected European banks to regain some ground. This trade has further to go, as valuation differentials remain excessive, especially since European banks are not as risky as they once were. Underweight / Short Norway As Hedge To Swedish Stocks This position is down 1% since inception. We have a cyclical overweight on the Swedish equity market (see page 9), which is extremely sensitive to the global industrial cycle. Thus, we were concerned by the potential near-term impact of the Chinese credit slowdown on this position. Selling Norway remains an appropriate hedge, because this market massively overweight materials stocks, which are even more exposed to the Chinese credit cycle than industrials are. Positive European Small-Cap Stocks This position is up 0.2% since inception. This was a bet on the economic re-opening taking place in the wake of the accelerating pace of vaccination in Europe. However, the weakness in the Euro since May has caused the large-cap European stocks to perform almost as well as their more-domestically focused counterparts. Neutral Stance On Cyclicals Relative To Defensives Chart 2The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance This trade is up 2.3% since inception. While we like cyclical plays on an eighteen to twenty-four months basis, we became concerned this spring about a tactical pullback. Globally, cyclical stocks had become extremely expensive and overbought relative to defensive sectors (Chart 2). Moreover, the rapid deceleration of the Chinese credit impulse pointed toward a period of negative economic surprises and was historically consistent with a period of underperformance of cyclical names. Now that China is stepping off the brake pedal, this trade is becoming long in the tooth. Neutral Stance On Europe Relative To The Rest of The World This trade is down 0.3% since its inception. This position is a corollary to the neutral view on cyclicals, as European equities possess a high beta. This bet did not pan out; European equities did underperform US stocks, but weaknesses in China and EM undid this benefit. Favoring Industrials Over Materials This trade is up 0.6% since inception. Industrial equities are less exposed to the Chinese credit slowdown than materials, but are more direct beneficiaries of the large infrastructure spending packages being rolled out across advanced economies. Industrials are also a direct bet on a capex recovery, which we expect to intensify over the next two years as companies address supply side issues. The tactical element of this trade may soon dissipate as China’s policy tightening ends, which would warrant booking profits. However, the industrials versus materials theme remains attractive as a cyclical bets on capex. Financials Over Other Cyclicals This trade is down 1.6% since inception. This was another trade aiming to keep some cyclical exposure on the book (long financials), while diminishing the exposure to the Chinese credit slowdown. The fall in yields and the weakness in the euro prevented this trade from working out. We now close this position. Long / Short Basket Based On Combined Mechanical Valuation Indicator This trade is flat since inception. This market-neutral trade uses the methodology developed in our May 31st Special Report in which we introduced our Combined Mechanical Valuation Indicator (CMVI). We bought the most undervalued sectors and sold the most overvalued. We will look to rebalance this portfolio in the coming months. Short Euro Area Energy Stocks / Long UK Energy Stocks Chart 3UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain This trade is up 7.5% since inception. This market neutral trade was fully based on the results from our CMVI (Chart 3). We are taking profits today. Short Consumer Discretionary / Long Telecommunication In Europe This trade is up 10.6% since inception. It is our favored way to express our tactical worries toward cyclical equities and the resulting preference for defensive stocks. Moreover, this trade is attractive from a valuation perspective, as the CMVI gap between discretionary and telecommunication equities is at a record high despite the higher RoE offered by telecom equities (Chart 4). Short Tech / Long Healthcare In Europe This trade is up 9.3% since inception. It is a low-octane version of the short discretionary / long telecommunications position. While it is a short cyclicals / long defensive trade, it does not have the long value / short growth overlay as its higher-octane cousin. However, it is also supported by attractive valuation differentials (Chart 5). Chart 4An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... Chart 5...and A Lower Octane Expression ...and A Lower Octane Expression ...and A Lower Octane Expression Favor Spain Over France This trade is down 2% since inception. Based on sectoral composition, the Spanish market is more defensive than that of France, which was an appealing characteristic considering our tactical worries for cyclical bets. Moreover, Spanish equities were more attractively priced. However, the Spanish economy has proven less resilient to the Delta variant than that of France. As a result, Spanish financials, which represent a large share of the national benchmark, have suffered. Underweight French Consumer Discretionary Equities Relative To Global Peers This trade is up 0.6% since inception. French discretionary stocks, led by beauty and luxury names, remain attractive structural plays. However, they have become expensive and risk temporarily underperforming their foreign competitors. Buy Swiss Equities / Sell Eurozone Defensive This trade is up 0.5% since inception. Due to their sectoral bias toward consumer staples and healthcare, Swiss equities are extremely defensive. However, they often outperform their Euro Area counterparts when Swiss yields rise relative to those of Germany. We do expect such widening to take place over the coming months. The ECB will continue to expand its balance sheet, which will force the SNB to become increasingly active about putting a floor under EUR/CHF. Historically, these processes boost Swiss stocks relative to Eurozone defensives. Buy European Momentum Stocks / Sell European Growth Stocks Chart 6The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further This trade is up 1.7% since inception. In Europe, momentum stocks are exceptionally oversold relative to growth stocks (Chart 6). As yields stabilize, momentum stocks are well placed to outperform growth equities. Moreover, this trade is a careful attempt to begin to move away from our defensive tactical stance as China backs away from policy tightening. More Value Left In European IG This trade is up 0.9% so far. European IG bonds have low spreads, but their breakeven spreads may narrow further as policy remains extremely accommodative and European growth continues to recover, even in the face of the Delta variant. In this context, we see the modest yield pick-up offered by these products as attractive, especially compared to the meagre yields generated by European safe-haven securities. Despite the modest success of the overall recommendation, the country implication did not work out as well. Overweight Italian And Spanish Bonds In Balance Portfolios This trade is up 0.2% since inception. Italian and Spanish government bonds are expensive in absolute terms, but compare well relative to French, Dutch, or German bonds. In a backdrop in which the ECB continues to purchase these instruments, where the NGEU funds create an embryo of fiscal risk-sharing within the EU and where growth is recovering, risk premia in the European periphery have room to decline further. Buy European Steepeners And US Flatteners As A Box Trade Chart 7Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners This trade is up 63 bps since inception. The ECB will lag behind the Fed, but market pricing already reflects this future. Meanwhile, the terminal policy rate proxy embedded in the EONIA and US OIS curves overstates how high the neutral rate is in the US compared to that of Europe (Chart 7). Thus, as the Fed begins to remove accommodation in the US, the US yield curve should flatten compared to that of Europe. Favor The GBP Over The EUR This trade is up 0.6% since inception. The pound is cheaper than the euro, and the domestic UK economy is well supported by the more advanced re-opening process. This combination will continue to hurt EUR/GBP. Sell EUR/NOK This trade is down 2.6% since inception. The NOK is cheaper than the EUR, and the Norges Bank will lead DM central banks in raising interest rates. Moreover, higher oil prices create a positive term of trade shock in favor of Norway. However, this trade has not worked out so far. Among G-10 currencies, the NOK (along with the SEK) is the most sensitive to the USD’s fluctuations. The rebound in the Greenback since March has therefore hurt this position significantly. Cyclical Recommendations Overweight Stocks Vs Bonds This position is up 7% since inception. European equities follow the global business cycle; while we warned a slowdown would take shape, growth is slated to remain above trend for the foreseeable future. Consequently, while we may adjust tactical positioning to take advantage of these gyrations in growth relative to expectations, our core cyclical view remains to overweight stocks within European balanced portfolios. Overweight Bank Equities Chart 8Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore This position is up 2.4% since inception. We have espoused the near-term decline in yields, but our big picture cyclical view remains that yields have more upside globally. An environment in which yields increase is one in which bank profit margins expand, which will in turn boost the relative return of cheap financial equities. Even though the long-term growth rate of bank cash flows warrants a discount, these firms’ valuations also reflect the perception that they carry elevated risks. However, if European NPLs have greatly improved, capital buffers have expanded significantly (Chart 8), and the ECB is unwilling to precipitate a crisis as it did ten years ago. In this context, the risk premia embedded in European bank valuations have room to decrease, which will boost the relative performance of these equities. Bullish German Equities (Absolute) This position is up 3.9% since inception. German stocks are a direct bet on the global economy, as a result of their heavy weighting in industrials and consumer discretionary stocks. Moreover, the German economy continues to fare well, boosted by a cheap euro and a low policy rate. Finally, we expect German fiscal policy to remain accommodative after the upcoming federal election weakens the power of the CDU. This combination will allow German stocks to generate further upside over the coming years. Favor Swedish Equites Over Eurozone And US Benchmarks Since inception, this position is up 0.9% on its European leg and is up 0.3% on its US leg. Sweden is a particularly appealing market despite its demanding valuations. The Swedish benchmark overweighs industrials and financials, two of our favorite sectors for the coming eighteen months. Moreover, the Swedish corporate sector’s operating metrics are robust, with wide profit margins, elevated RoEs, and comparatively healthy levels of leverage. Finally, the SEK is one of our favored currencies on a twenty-four-month basis, because it has a strong beta to the USD, which BCA expects to depreciate on a cyclical time frame. Buying Sweden versus the Eurozone has worked out, but selling the US market has not, because yields experienced a countertrend decline. Once global yields begin to rise anew and Chinese credit growth begins to recover, Swedish equities should also beat their US peers. Long Swedish Industrials / Short Eurozone And US Industrials Chart 9Favor Swedish Industrials Favor Swedish Industrials Favor Swedish Industrials This position is up 3% on its European leg and 8.5% on its US one. This market neutral position narrows in on the very reason to favor Swedish equities: industrials. As is the case for the overall market, Swedish industrials offer stronger operating metrics than their counterparts in both the Eurozone and the US (Chart 9). Additionally, the early positioning of Sweden in global supply chains adds some operating leverage to these firms, which gives them an advantage in an environment of continued inventory rebuilding, infrastructure spending, and capex plans around the world. Underweight German Bunds Within European Fixed-Income Portfolios German bund yields have declined 15bps since inception. German Bunds suffer from their extremely demanding valuations versus other European fixed-income securities. As long as global and European growth remains above trend, German yields should underperform other European fixed-income assets, even if the ECB stands pat for the foreseeable future (which would force greater spread compression across European markets). Weakness In EUR/USD Creates Long-Term Buying Opportunities Earlier this spring, we expected the dollar to experience a counter-trend bounce as a result of skewed positioning and the potential for a decline in global growth surprises. However, BCA’s cyclical view calls for a weaker USD because of the US balance of payments deficit, the greater tolerance of the Fed for higher inflation, and the overvaluation of the Greenback. Based on these diverging forces, we continue to recommend investors use the current episode of weakness in EUR/USD as an opportunity to garner more exposure to the euro. Short EUR/SEK This position is down 0.6% since inception. The SEK is even more sensitive to the dollar’s gyration than the euro. Moreover, beyond some near-term disappointment in global economic activity, we expect global growth to remain generally robust over the coming eighteen months. This combination will allow the SEK to appreciate versus the EUR, especially when Sweden’s domestic economic activity and asset markets are stronger than that of the Eurozone. Structural Recommendations A Structural Underweight On European Financial Chart 10Too Much Capital Too Much Capital Too Much Capital This long-term position is at odds with our near-term optimism about the sector. However, Europe has an excessively large capital stock, which, relative to GDP, dwarves that of the US or China (Chart 10). This phenomenon hurts rate of returns across the region and will remain a long-term structural handicap for the financial industry. Hence, investors with long investment horizons should use the expected rebound in European financials over the next year or two to diminish further their exposure to that sector. Norwegian Equities Remain Challenged As Long-Term Holdings Norwegian stocks overweight the financials, materials, and energy sectors. While materials face a bright future as electricity becomes an even more important component of the global energy mix, financials and energy face deep structural headwinds. Moreover, the krone faces its own structural challenges (see below). This combination augurs poorly for the long-term rates of return of Norwegian stocks. Overweight French Industrials Relative To German Ones This position is a bet on the continuation of the reform efforts of the French economy. BCA expects Emmanuel Macron to win a second mandate next year, which should result in additional reforms to the French economy. As a result, the French unit labor costs should remain contained relative to those of Germany. This process will help the profit margins of French industrial firms relative to that of their competitors across the Rhine. Overweight French Tech Equities Relative To European Ones French tech stocks will benefit from the greater R&D subsidies and budgets promoted by the French government. The Euro Will Underperform Pro-Cyclical European Currencies The Swedish krona and the British pound are particularly attractive versus the euro on a long-term basis. They benefit not only from their cheaper valuations, but also from the fact that the Riksbank and the Bank of England will tighten policy considerably ahead of the ECB. Additionally, the SEK and the GBP are now both more pro-cyclical than the euro. The Norwegian Krone Faces Structural Challenges The NOK is cheap and may even benefit in the coming month from its historical pro-cyclicality. However, Norway suffers from declining productivity relative to that of its trading partners, which creates a strong long-term handicap for its currency. As a result, long-term investors should withdraw from the NOK.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Road So Far The Road So Far Cyclical Recommendations The Road So Far The Road So Far Structural Recommendations The Road So Far The Road So Far ​​​​​​​ Currency Performance Fixed Income Performance Equity Performance  

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Global Policy Uncertainty Revives Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 10US Ends Trade War With Europe? Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk Russia's Domestic Political Risk Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Cyber Security Stocks Recover Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Long UK Versus Eastern Europe Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Long GBP Versus CZK Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 20Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 21BGerman Greens Still Underrated Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 23Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Mexico To Outperform Latin America Mexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America China's Slowdown Will Hit South America China's Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Climbing Swiss Peaks Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone A Good Sign For The Eurozone A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Sweden Leads The Eurozone Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Accelerating Vaccinations Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus A Surprising Dance A Surprising Dance Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Ample European Pent-up Demand Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises Decomposing The Surprises Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns A Surprising Dance A Surprising Dance The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks A Surprising Dance A Surprising Dance Table 3A Bullish Backdrop For EUR/USD A Surprising Dance A Surprising Dance The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Rising German Yields? Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth Support For Household Net Worth Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More UK Consumption Will Rise More UK Consumption Will Rise More Chart 12Accelerating UK Inflation Accelerating UK Inflation Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Deteriorating Profit Performance Deteriorating Profit Performance Chart 16Quite The Valuation Premium Quite The Valuation Premium Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead Lower EUR/GBP Ahead Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance A Surprising Dance A Surprising Dance Fixed Income Performance Government Bonds A Surprising Dance A Surprising Dance Corporate Bonds A Surprising Dance A Surprising Dance Equity Performance Major Stock Indices A Surprising Dance A Surprising Dance Geographic Performance A Surprising Dance A Surprising Dance Sector Performance A Surprising Dance A Surprising Dance ​​​​​​​ Closed Trades