Currencies
Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles. Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5). Chart 4Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… Chart 8...Especially Against The Euro The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Although Central European countries are not at risk from Russia’s military attack, their financial markets will remain jittery for a while. Central European financial markets, namely Poland, Hungary, and Czech Republic, have sold off due to the ongoing war…
Executive Summary Stronger Capex Than Last Decade The fog of war continues, but the worst potential outcome for the market—a freeze of Russian energy exports to Europe—has been avoided. Energy inflation is reaching its apex. Markets will remain volatile in the near term as uncertainty remains elevated in the coming days. Moreover, a transition from a recovery driven by consumer durable goods to services remains a hurdle against near-term European outperformance. Italian bonds and European banks are attractive, but it is not yet prudent to plunge headfirst into the euro. The longer-term consequences of the conflicts point toward greater capex and public deficits in Europe. This will boost the neutral rate of interest and European yields. Industrials and defense stocks are also key structural beneficiaries. Bottom Line: Keep hedges in place for the near term, as uncertainty remains rife. Buy Italian bonds and European banks, which will benefit from ECB support. Industrials still face near-term hurdles but should be a structural overweight position in European equity portfolios, along with financials and defense stocks. Feature The situation in Ukraine is reaching a climax. Following Russia’s recognition of the breakaway Luhansk and Donetsk People’s Republics (LPR and DPR) and its invasion of Ukraine, the S&P 500 entered correction territory. Importantly, the Dow Jones Euro Stoxx 50 is now down 10% since its January 5th high, which validates our repeated call over the past four weeks to hedge risk asset portfolios by selling EUR/CHF and EUR/JPY. An international conflict has begun and a human tragedy is unfolding; but, at the time of writing, it looks like the worst-case scenario for markets will be avoided. Germany is folding Nord Stream 2 indeterminably and Western allies have imposed painful economic sanctions on Russia. However, an expulsion of the SWIFT payment system is not in the cards. This is crucial because it greatly limits the risk that Russia will stop sending natural gas and oil to the EU. Ultimately, neither Russia nor the EU wants this outcome, since it imposes an enormous loss of revenues on the former (which needs hard currency to finance its war) and guarantees a recession for the latter (Chart 1). The war will still cost Europe. European natural gas prices surged again on Thursday, rising by more than 60% intraday. While a spike above EUR200/MWh is unlikely in the absence of an oil embargo, 20% of European natural gas imports pass through Ukraine. The conflict suggests that these flows will remain disrupted for now and that natural gas prices will remain between EUR80/MWh and EUR100/MWh for the next few months. This translates into elevated energy and electricity costs for the EU (Chart 2). Chart 1A European Recession Averted Chart 2Peaking But Elevated Chart 3Ebbing Energy Inflation Oil markets are set to peak soon. The run-up in Brent prices in recent weeks was largely driven by geopolitical concerns. With the odds of an oil embargo declining, the pressure on Brent will also recede. Bob Ryan, BCA’s commodity and energy strategist, believes that Saudi Arabia, the UAE, and Kuwait will increase their own production in coming weeks to burnish their credentials as reliable oil producers, especially if oil experiences more turmoil. Bob expects crude prices to drop to $85/bbl by the second half of 2022. These dynamics are important because they imply that European headline inflation will soon peak. Yes, the recent spike in natural gas prices will keep energy inflation higher for a few more months, but, ultimately, ebbing base effects will bring down energy CPI. As Chart 3 highlights, even if Brent and natural gas prices stay at today’s levels for the remainder of the year, their year-on-year inflation rates will collapse, which will drive HICP lower. Near-Term Market Dynamics In this context, what to do with European assets? It is probably still too early to abandon our hedges, but we will likely do so next week or soon after. While the market has probably bottomed, prudence remains of prime consideration as a war is taking place and the situation on the ground may deteriorate. Chart 4A Buying Opportunity The clearest near-term investment implication comes for European peripheral bonds. Italian spreads have widened significantly in the wake of the hawkish pivot by the ECB (Chart 4). However, we argued that, when interest rate expectations priced in 50bps of the hike for 2022, the move was excessive and that only one ECB hike in the fourth quarter was likely this year. Now that the Ukrainian crisis is reaching a climax, even some of the ECB’s most hawkish members, such as Robert Holzmann, Governor of the Austrian National Bank, indicate that the removal of liquidity will be slower than originally anticipated. This means that the ECB is likely to continue to backstop the European peripheral bond markets. Italian and Greek bonds, which offer spreads of 165bps and 249bps over German bunds, are appealing in light of this explicit backstop. European financials are another attractive buy. Investors should buy banks outright. As Chart 5 highlights, all the major Eurozone countries’ banking stocks have suffered widespread selloffs. However, the exposure to Russian debt is limited at $67 billion (Chart 6). Additionally, the European yield curve slope is unlikely to flatten significantly from here. The ECB will limit the upside in the German 2-year yields by not hiking until Q4 2022, while the terminal rate proxy in Europe has significant upside from here. A steeper yield curve will boost the appeal of banks, especially in a context in which peripheral spreads are likely to narrow. Chart 5Too Much Of A Dive Chart 6Limited Russian Exposure The outlook for the euro is more complex. Narrower peripheral spreads would boost the euro’s appeal, a cheap currency currently trading at a 17% discount to its PPP fair value. EUR/USD also trades at a 5% discount to the BCA Intermediate-Term Timing Model, which suggests that considerable bad news is already embedded in the exchange rate (Chart 7). The fact that the EUR/USD did not close below its January 27th low in the face of a major war on European soil adds to the notion that the euro already embeds a significant risk premium. However, there are still ample reasons to worry about additional volatility in the coming week or so. The ECB is sounding less hawkish, while the Fed is not changing its tone. Meanwhile, 1-month and 3-month risk reversals are not at levels consistent with a bearish capitulation, which suggests that the euro could suffer one last wave of liquidation (Chart 8). Thus, we are not buying the euro yet and are willing to forego the first few cents of gains for a clearer signal. Chart 7EUR/USD Is Cheap Chart 8Sentiment Could Get More Negative Circling back to the equity front, European equities had become very oversold after the 14-day RSI fell below 30. The diminishing risk of an energy crisis will also help. However, global equities face more risks than just Ukraine. As we wrote earlier this week, the transition away from consumer durable goods as the driver of global growth to services will involve some adjustments for stocks, especially in an environment in which the Fed is allowing global monetary conditions to deteriorate (Chart 9). Thus, the window of volatility in stocks is unlikely to close in the near term. The relative performance of European equities vis-a-vis the US is complex as well. European equities have undone most of the relative gains accrued so far in 2022 (Chart 10). On the one hand, the global growth transition will hurt European equities more than US ones, as a result of their greater exposure to manufacturing activity. Additionally, high energy costs are more of a problem for Europe right now than the US. On the other hand, the continued hawkishness of the Fed is likely to limit the ability of tech stocks to extend the rebound that began last Thursday. As a result, the most likely pattern is for some churning in the relative performance of Europe and the US in the coming week. Chart 10Vanishing Outperformance Chart 9Tightening US Liquidity Conditions For the remainder of the year, we expect the European equity outperformance to re-establish itself in view of the favorable relative profits picture for 2022, a topic that we will explore more deeply in the coming weeks. Bottom Line: The near-term outlook for European assets remains extremely murky. Not only is a war in Ukraine a major threat that can hurt sentiment further, but European assets still have to handle the short-term implications of a change in global growth leadership away from goods consumption. Nonetheless, the dovish message of the ECB in the wake of the Ukrainian invasion suggests that the collapse in Italian bonds and European banks in recent weeks is overdone. European stocks will likely continue to churn against US stocks in the near term but outperform for the remainder of the year. The sell-off in the euro is advanced, but prudence prevents us from buying EUR/USD today. Keep short EUR/CHF and short EUR/JPY hedges in place for now. Longer-Term Implications The crisis in Ukraine heightens Europe’s need to diversify its energy sourcing away from Russia. However, this is not a transition that can be executed on a dime. It will take years. For now, Europe remains dependent on Russian energy, which greatly limits the EU’s options. However, time offers many more possibilities. First, kicking Russia out of SWIFT will become feasible, because it will increase the robustness of the SPFS payment system, allowing Russia to receive funds for its energy, even if it is out of SWIFT. Second, and most importantly, time will allow Europe to find new energy sources. For example, Qatari LNG is often mentioned as a potential replacement for Russian natural gas. Qatar currently does not have the capacity to service Europe extensively, while fulfilling its previous contractual obligations, but the expansion of the production in its North Field East will increase capacity to 126MTPA by 2027. The LNG export capacity of the US may also increase over the coming years. Even if Qatar and the US could send enough LNG to satisfy the hole left by Russia tomorrow, Europe would not be able to accept delivery, as it does not have enough terminals to accommodate these shipments. Thus, investments in that sector will expand. Chart 11The Renewables Envelope Will Expand Chart 12Nuclear Skepticism Remains Most importantly, Europe will accelerate its transition toward renewable energy. Renewables are already a major focus of the NGEU program (Chart 11). However, we expect that, for the remainder of the decade, the NGEU program will be enlarged to allow greater investments in that space. Not only does it fit European green goals, but this policy would also increase the region energy security. More investment in nuclear electricity production is also possible but lacks popular support (Chart 12). The main message of these observations is that European infrastructure spending is likely to remain elevated in the coming years. As a result, industrial stocks may face some near-term headwinds as the global economy transitions away from the consumer goods-buying binge of COVID-19, but they will ultimately benefit greatly from an expansion of the capital stock around the world. Another long-term theme derived from the current crisis is that European defense stocks will fare well on a structural basis. The current crisis will force greater European unity. The presence of a common enemy will incentivize European nations to increase military spending, especially as the US continues to pivot toward Asia. Investors should overweight these stocks. In terms of bond market developments, more military spending and investment in energy infrastructures means that European budget deficits will be wider than if the Ukrainian crisis had not emerged. More accommodative fiscal policy will support aggregate demand, which will feed through greater capex (Chart 13). Thus, the experience of the last decade, whereby aggregate demand was curtailed by unnecessarily stringent European fiscal policy, will not be repeated. This confirms our expectation that the neutral rate of interest will rise in Europe and that Europe will escape an environment of zero rates (Chart 14). Therefore, German bunds yields have upside, the yield curve can steepen, and the outlook for European financials is positive on a long-term basis, not just on a near-term one. Chart 13Stronger Capex Than Last Decade... Chart 14...Means Higher Yields And A steeper Curve Chart 15Ebbing Fixed-Income Outflows? Finally, the picture for the euro is murky. On the one hand, its inexpensiveness is a major advantage while a higher neutral rate of interest will limit the European fixed-income outflows that have plagues the Euro for the past decade (Chart 15). However, if we are correct that European capex will increase and that budget deficits will remain wider than in the last decade, this also means that the European current account surplus will narrow as excess savings recede. This implies that one of the key underpinnings of the euro will dissipate. In the end, productivity will be the long-term arbiter of the exchange rate. Europe still lags behind the US on this front, which augurs poorly for the performance of the euro (Chart 16). Reforms and capex may save the day, but it is too early to make this call. Chart 16The Productivity Handicap Bottom Line: The events in Ukraine portend a structural shift in European capex. Europe will need to ween itself off its Russian energy dependency, which will require major investments in LNG facilities and renewable power. Moreover, European defense spending will rise. These will continue to support fiscal and infrastructure spending. As a result, industrials will benefit from a structural tailwind, as will European defense stocks. These same forces will put upward pressure on European risk-free yields, which will benefit beleaguered European financials and banks. The long-term outlook for the euro is murkier. More research must be conducted before making a definitive directional bet. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations
Dear client, In addition to this weekly report, we sent you a Special Report from our Geopolitical Strategy service, highlighting the risk from the Russo-Ukrainian conflict. Kind regards, Chester Executive Summary The Ukraine crisis will lead to a period of strength for the DXY. Countries requiring foreign capital will be most at risk from an escalation in tensions. Portfolio flows have reaccelerated into the US, on the back of a rise in Treasury yields. This will be sustained in the near term. The euro area on the other hand has already witnessed significant portfolio outflows, on the back of Russo-Ukrainian tensions and an energy crisis. Countries with balance of payment surpluses like Switzerland and Australia are good havens amidst the carnage. Oil-producing countries such as Norway and Canada have also seen an improvement in their balance of payments, on the back of a strong terms-of-trade tailwind. This will be sustained in the near term. Balance Of Payments Across The G10 Bottom Line: The dollar is king in a risk-off environment. That said, the US and the UK sport the worst balance of payments backdrops, while Norway, Switzerland, and Sweden have the best. This underpins our long-term preference for Scandinavian currencies in an FX portfolio. In the near term, we think the DXY will peak near 98-100, but volatility will swamp fundamental biases. Feature Chart 1The US Runs A Sizeable Deficit The Russia-Ukraine conflict continues to dictate near-term FX movements. With Russia’s invasion of Ukraine, the risk of escalation and/or a miscalculation has risen. FX volatility is increasing sharply, and with it, the risk of a further selloff in currencies dependent on foreign capital inflows. As a reserve currency, the dollar has also been strong. It is difficult to ascertain how this imbroglio will end. However, in this week’s report, we look at which currencies are most vulnerable (and likely to stay vulnerable) from a balance of payments standpoint. Chart 1 plots the basic balance – the sum of the current account balance and foreign investment – across G10 countries. It shows that at first blush, Norway, Switzerland, Sweden, and Australia are the most resilient from a funding standpoint, while New Zealand, the UK, and the US are the most vulnerable. In Chart 2, we rank G10 currencies on eight different criteria: The basic balance, which we highlighted above. Real interest rate differentials, using the 10-year tenor and headline inflation. Relative growth fundamentals, as measured by the Markit manufacturing PMI. Three fair value models which we use in-house. The first is our Purchasing Power Parity model, which adjusts consumption basket weights across the G10 to reflect a more apples-to-apples comparison. The second is our long-term fair value model (LTFV), which adjusts for productivity differentials between countries; and the final is our intermediate-term timing model (ITTM), which separates procyclical from safe-haven currencies by including a risk factor such as corporate spreads. All three models are equally weighted in our rankings. The net international investment position (NIIP), which highlights currencies that are most likely to witness either repatriation flows or a positive income balance in the current account. Finally, net speculative positioning, which tells us which currencies have crowded long positions, and which ones sport a consensus sell. Chart 2The Scandinavian Currencies Are Attractive The conclusions from this chart are similar to our basic balance scenario – NOK, SEK, AUD, CHF, and JPY stand out as winners while GBP, NZD, and USD are the least attractive. The US dollar is a special case given its reserve currency status, with a persistent balance of payments deficit. The rise in the greenback amidst market volatility is a case in point. However, portfolio flows into the dollar also tend to be cyclical, so a resolution in the Ukraine/Russia conflict will put a cap on inflows. Equity portfolio flows had dominated financing of the US current account deficit but are relapsing (Chart 3). Bond portfolio flows have rebounded on the back of rising US yields, but US TIPS yields remain very low by historical standards (Chart 4). If they do not improve much further, specifically relative to other developed markets, it will be tough to justify further inflows into US Treasurys. Chart 3Equity Portfolio Flows Into The US Are Relapsing Chart 4Bond Portfolio Flows Into The US Are Strong In this week’s report, we look at the key drivers of balance of payments dynamics across the G10, starting with the US, especially amidst a scenario where the forfeit of foreign capital could come to the fore. United States Chart 5US Balance Of Payments The US trade deficit continues to hit record lows at -$80.7 billion for the month of December. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasurys. A positive net income balance has allowed a slower deterioration in the US current account balance, though at -$214.8 billion for Q3, it remains close to record lows. The overall picture for both the trade and current account balance is more benign as a share of GDP, given robust GDP growth (Chart 5). That said, as a share of GDP, the trade balance stands at -3.5%, the worst in over a decade. Foreign direct investment into the US has been improving of late. This probably reflects an onshoring of manufacturing, triggered by the Covid-19 crisis. That said, despite this improvement, the US still sports a negative net FDI backdrop. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is still deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts worsening. Euro Area Chart 6Euro Area Balance Of Payments The trade balance in the euro area has significantly deteriorated in recent quarters, on the back of an escalating energy crisis. Russia’s invasion of Ukraine marks the cherry on top. On a rolling 12-month basis, the trade surplus has fallen to 1% of GDP (Chart 6). This is particularly telling since for the month of December, the trade balance came in at €-4.6 billion, the worst since the euro area debt crisis. The current account continues to post a surplus of 2.6% of GDP, on the back of a positive income balance. However, FDI inflows are relapsing. After about two decades of underinvestment in the euro area, FDI inflows were at their highest level, to the tune of about 2% of GDP in 2021. Those have now completely reversed on the back of uncertainty. The combination of an energy crisis and dwindling FDI is crushing the euro area’s basic balance surplus. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Should the deterioration continue, it will undermine our longer-term bullish stance on the euro. It is encouraging that portfolio investments have turned less negative in recent quarters, as bond yields in the euro area are rising. Should this continue, it will be a good offset to the deterioration in FDI. Japan Chart 7Japan Balance Of Payments Like the euro area, the trade balance in Japan continues to be severely hampered by rising energy imports. The trade deficit in January deteriorated to a near record of ¥2.2 trillion, even though export growth remained very robust. Income receipts from Japan’s large investment positions abroad continue to buffer the current account, but a resolution to the energy crisis will be necessary to stem Japan’s basic balance from deteriorating (Chart 7). The process of offshoring has sharply reversed since the Covid-19 crisis. While FDI is still deteriorating, it now stands at -2.4% of GDP, compared to -4.3% just before the pandemic. Net portfolio investments are also accelerating, especially given the rise in long-term interest rates in Japan, positive real rates, and the value bias of Japanese equities. We are buyers of the yen over the long term, but a further rise in global yields and energy prices are key risks to our view. United Kingdom Chart 8UK Balance Of Payments The UK has the worst trade balance in the G10, and the picture has not improved much since the pandemic (currently at -6.7% of GDP). Similar to both the euro area and Japan, much of the drag on the trade balance has been due to rising import costs from energy and fuels. This puts the UK at risk of an escalation in the conflict between Ukraine and Russia. Meanwhile, the improvement in the income balance over the last few years has started to deteriorate, as transfer payments under the Brexit withdrawal agreement kick in. As a result, the current account balance is deteriorating anew (Chart 8). Both portfolio and direct investment in the UK were robust in the post-Brexit environment but have started to deteriorate. This is critical since significant foreign investment is necessary to boost productivity in the UK and prevent the pound from adjusting much lower. With bond yields in the UK rising, and the FTSE heavy in cyclical stocks, this should limit further deterioration in the UK’s financial account. A significant drop in the estimated path of settlement payments for Brexit will also boost the income balance. The key for the pound over the coming years remains how fast the UK can improve productivity, which will convince foreign investors that the return on capital for UK assets will increase. Canada Chart 9Canada Balance Of Payments Canada’s domestic economy has been relatively insulated from the geopolitical shock in Europe, but its export sector is benefiting tremendously from it. Rising oil prices are boosting Canadian terms of trade. As a result, the current account has turned into a surplus for the first time since 2009, in part driven by an improving trade balance (Chart 9). Outside of trade, part of the improvement in the Canadian current account balance is specifically driven by income receipts from Canada’s positive net international investment position. At C$1.5 trillion, income receipts are becoming an important component of the current account balance. Foreign direct investment into Canada continues to remain robust, given strong commodity prices. This is boosting our basic balance measure, which today sits at a surplus of 2.4% of GDP and should continue to improve. Finally, because of Canada’s improving balance-of-payments backdrop, it is no longer reliant on foreign capital as it had been in the past, which supports the loonie. Australia Chart 10Australia Balance Of Payments Australia continues to sport the best improvement in both its trade and current account balances over the last few years. As a result, the basic balance has eclipsed 4% of GDP for the first time since we have been measuring this series (Chart 10). The story for Australia remains improving terms of trade, specifically in the most desirable commodities – copper, high-grade iron ore, liquefied natural gas, and to a certain extent, high-grade coal. Foreign direct investment in Australia has eased significantly. Investment in projects in the resource space are now bearing fruit, easing the external funding constraint. Meanwhile, domestic savings can now be easily recycled for sustaining capital investment. In fact, foreign direct investment turned negative in Q4 2021. This also explains the drop in net portfolio investment since Australians now need to build a positive net international investment position. We have a limit buy on the Aussie dollar at 70 cents, as we are bullish the currency over a medium-term horizon. New Zealand Chart 11New Zealand Balance Of Payments For the third quarter of 2021, New Zealand’s current account balance hit record lows, despite robust commodity (agricultural) prices. Imports of fertilizers, crude oil, and vaccines have led to a widening trade deficit. A drop in the exports of wood also affected the balance. With a negative net international investment position of about 48% of GDP, the income balance also subtracted from the current account total (Chart 11). From a bigger-picture perspective, New Zealand’s basic balance has been negative for many years, as coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities, have kept the current account in structural deficit. However, as the prices of key agricultural goods head higher, New Zealand can begin to benefit from a terms-of-trade boom that will limit its external funding requirement. In that respect, portfolio investments are also improving. New Zealand has the highest bond yield in the G10, on the back of the highest policy rate so far (the RBNZ raised interest rates again this week). New Zealand’s defensive equity market has also corrected sharply amidst the general market riot. As such, foreign investors could begin to favor this market again based on high yields and a reset in valuations. Going forward, New Zealand should continue to see further improvement in its basic balance relative to the US, supporting the kiwi. Switzerland Chart 12Switzerland Balance Of Payments The Swiss trade balance remains in a structural surplus, with a post Covid-19 boom that has led a new high as a share of GDP (Chart 12). Global trade has been rather resilient due to high demand for goods. While Switzerland has a large net international investment position, income flows this quarter were hampered by servicing costs for foreign direct investments. The net international investment position did improve by CHF27 billion on a quarter-over-quarter basis in Q3, on the back of a net increase in foreign asset purchases. Currency movements also had little impact on the portfolio in Q3, which is atypical. The SNB will always have to contend with a structural trade surplus that puts upward pressure on the currency. This will keep the Swiss franc well bid, especially in times of crisis when the positive balance-of-payments backdrop makes the CHF a safe haven. Norway Chart 13Norway Balance Of Payments Q3 2021 saw a strong recovery in Norway’s trade account that is likely to carry over to this year. A recovery in crude oil and natural gas prices was a welcome boon. The lack of tourism also boosted the services account (Norwegians travel and spend less abroad than foreigners visiting Norway). The ongoing electricity crisis in Europe was also an opportune export channel for Norway, which for the first time, opened its 450-mile-long, 1400-megawatt North Sea cable link to the UK. Positive income flows also benefit the current account and the krone (Chart 13). With one of the largest NIIPs in the world heavily skewed towards equity dividends, the NOK benefits when yields rise, even though the domestic fixed-income market is highly illiquid. While a resolution of the Russian-Ukrainian crisis could sap the geopolitical risk premium from oil, the reopening of the global economy will benefit Norwegian exports of oil and gas. Tepid investment in global oil and gas exploration will also ensure Norway’s terms of trade remain robust. Sweden Chart 14Sweden Balance Of Payments The Swedish current account balance has deteriorated slightly in the last few quarters, on the back of supply-side bottlenecks. Particularly, exports of cars have been hampered amidst a semiconductor shortage. That said, the primary income surplus remains a key pillar of the current account, keeping the basic balance at a healthy surplus of about 6% of GDP (Chart 14). Portfolio inflows into Sweden have dwindled, like most other European economies. If this has been due to geopolitical tensions in Europe, it will eventually prove to be fleeting. That said, the Riksbank remains one of the most dovish in the G10 and the OMX is also one of the most cyclical stock markets, which may have spooked short-term foreign investments. The Swedish krona has been the weakest G10 currency year-to-date. Given that we expect most of the headwinds to be temporary, and the basic balance backdrop remains solid, we will go long SEK versus both the euro and the US dollar. 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
The greenback typically benefits from a flight to safety amid periods of elevated geopolitical tensions. We recently showed that the dollar strengthens when global uncertainty increases. However, the latest bout of geopolitical tensions on the back of the…
Executive Summary Lots Of Pent-Up Demand The yen is unlikely to meaningfully appreciate until global bond yields stabilize. That said, very cheap valuations and a large net short position provide ample ammunition for an explosive rebound should macroeconomic conditions fall into place. The macro catalyst is likely to come from a domestic growth rebound. Unlike other developed economies, private consumption in Japan has been rather anemic on the back of cascading lockdowns. Inflation in Japan will remain contained in 2022, meaning the Bank of Japan will stay dovish. That said, the Japanese economy is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 104. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Recommendations Inception Level Inception Date Return Short CHF/JPY 125.05 2022-02-17 - Bottom Line: Real rates are likely to remain quite attractive in Japan. While that has not been a key driver of the currency in the short term, it remains an anchor over a longer horizon. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns. Feature Chart 1Anemic Passenger Volumes The Japanese economy grew by 1.7% in 2021. For an economy with a potential growth rate of only 0.5%, this is an impressive feat. Even more remarkable is that this growth occurred within the context of very anemic domestic demand. The external sector in Japan has been benefiting from a global trade boom, while the domestic sector has been under siege from the pandemic. Anecdotally, the situation on the ground remains rather dire. Shinkansen passenger volumes are still down 35% this year after an even bigger collapse last year. According to Nikkei Asia, the waiting list to enter Japan continues to grow, as border restrictions are enforced. Of the 626,000 individuals approved for residence in Japan since January 2020, only 35% have filtered through. More broadly, at the peak, tourist arrivals (a meaningful source of demand) represented 25% of the overall Japanese population. Today, that number remains near zero (Chart 1). Amidst the gloom, pockets of Japanese financial markets are beginning to suggest a turnaround in economic conditions. The yield curve in Japan is steepening, usually a sign that monetary conditions remain very conducive to growth. Historically, that has been a bullish signal for the yen (Chart 2). Meanwhile, despite the surge in global bond yields, Japanese bank stocks are outperforming. The banking sector is usually one of the first to sniff out an improvement in economic fortunes (Chart 3). Chart 2The Yen And The Japanese Yield Curve Chart 3Japanese Banks Are Outperforming Outside financials, with inflation surging around the world, the Japanese economy is one of the best candidates for generating non-inflationary growth. This is bullish for the currency as real rates rise. Our bias is that while it might be too early to go long the yen today, conditions are gradually falling into place for a coiled spring rebound. The Case For Japanese Growth While the manufacturing PMI in Japan hit an 8-year high of 55.4 in January, the services PMI sits at 47.6, the lowest in the G10. The number of daily new COVID-19 cases breached 100,000 this month, the highest since the pandemic began two years ago. Hospitalizations and deaths are also rising acutely. However, there is rising evidence that Japan is beginning to put the worst of the pandemic behind it. 79.5% of the population is fully vaccinated, versus just about 50% six months ago. Booster shots are being ramped up quickly. The effective reproduction rate of the virus has dropped sharply, from 2.29 at the end of last year to 1.19 currently. According to government officials, there will be sufficient progress made on the virus front to begin relaxing border requirements and restrictions by next month. Optimism on the COVID-19 front will be a welcome fillip to much subdued consumer and business sentiment. Consumption outlays in Japan remain well below the pre-pandemic trend, especially towards services (Chart 4). As the economy reopens, and the labor market recovery continues, the war chest of Japanese savings that have been built in recent years should be modestly unwound. The job-to-applicants ratio is inflecting higher and workers’ propensity to consume has been improving (Chart 5). Chart 5A Labor Market Recovery Will Boost Spending Chart 4Lots Of Pent-Up Demand Wage increases remain very modest in Japan. Fumio Kishida, the Japanese prime minister has called for wage increases above 3%. His government also wants to raise the minimum wage from ¥930 to ¥1000, after a 3% increase last year. As the Shuntō (spring wage negotiations) begin, unions are likely to become more vocal in demanding wage increases. However, with a large share of temporary workers in Japan, and company preferences for one-time bonuses versus permanent pay increases, overall wage growth in Japan should remain in the 1-2% range, in line with BoJ forecasts. This puts Japan miles away from a wage inflation price spiral. From a contrarian perspective, it also means that falling unit labor costs are making the currency extremely competitive (Chart 6). Chart 6Japanese Workers Are Both Productive And Competitive Chart 7A Smaller Fiscal Drag In 2022 In a nutshell, Japan has had cascading shocks from the consumption tax hike in 2019 to six waves of COVID-19 over the last two years. These have led to a massive build in pent-up demand, which should be unleashed in the coming quarters. Government outlays will also go a long way towards boosting aggregate demand. A supplementary budget of ¥36tn was put together last year and approved for the fiscal year that ends this April. The even bigger 2022 budget of ¥107.6tn should also help ease the fiscal drag in 2022 (Chart 7). For a low-growth economy like Japan, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. The Export Machine Continues To Hum A boom in external demand has been a much welcome cushion for Japanese growth. Rising energy prices are hurting the nominal trade balance, but real net exports remain firm. Foreign machinery orders are still rising over 30% year on year, boosting industrial production in Japan (Chart 8). Demand from China has been an important component of foreign sales. As monetary policy is eased in Beijing, domestic demand should start to improve, preventing Japanese exports from collapsing. One of the most cyclical components of Japanese exports is machine tool orders, which remain firm (Chart 9). Chart 9A Chinese Recovery Will Cushion Export Growth Chart 8Machinery Orders Remain Robust Monetary Policy And Inflation The Bank of Japan is unlikely to adjust monetary settings aggressively, amidst a recovery in demand. It could widen the target band for yield curve control, while bringing short rates back to zero, but this will require a vigorous rebound in demand and inflation. It could also scrap its 0% bank loan scheme but given these are targeted (especially towards renewable industries, and small/medium-sized firms), that is unlikely. Remarkably, the BoJ has not had to increase its holdings of government securities over the last year, as markets have viewed its policy as credible (Chart 10). Doing little is likely the best path of action for the BoJ in 2022. Chart 112% Inflation = Mission Impossible? Chart 10Not Much QE By The BoJ The key variable for the BoJ remains its 2% inflation target, which seems elusive for the time being. Inflation does not tend to accelerate in Japan until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ (Chart 11). Moreover, the decline in phone charges has been structural, even though it is usually touted as a one-off. A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 20% every year to generate 2% inflation in Japan (Chart 12). The pass-through is likely to be much higher for price-volatile items such as food and energy, which is likely to create angst among the rapidly ageing population. Chart 122% Inflation = 20% Yen Depreciation Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. The Yen And Portfolio Flows It will be very difficult for the yen to rally if global yields continue to rise aggressively (Chart 13). With yield curve control in Japan, the nominal spread with foreign yields has been narrowing. However, the cost of hedging those foreign yields has also risen dramatically, which has prevented Japanese investors from aggressively flocking to overseas fixed income markets (Chart 14). That said, the weakness in the yen also suggests speculators have been borrowing in JPY to bet on carry strategies. Chart 13Global Yields Need To Stabilize To Cushion The Yen Chart 14No Massive Outflows From Japan Yet The rise in Treasury yields has yet to hit exhaustion from a technical perspective. Our bond strategists expect the 10-year yield to reach 2.25%, which will also enter the zone where we have historically seen some consolidation. The J.P. Morgan survey shows that most of its clients are short duration, but speculators are only modestly short 10-year or 30-year Treasurys (Chart 15). Chart 16USD/JPY And DXY Tend To Move Together Chart 15Modest Upside In Treasury Yields? Once yields stabilize, and the dollar starts to weaken, the positive real rate spread between Japan and the US should attract yen inflows, or at least nudge speculators to start liquidating massive short positions. As a counter-cyclical currency, the yen usually weakens against other developed market currencies, but USD/JPY tends to fall, on broad dollar weakness (Chart 16). Finally, the recent turbulence in markets has seen the yen begin to shine as a safe haven, more so than the US dollar and the Swiss franc (Chart 17). In the near term, this is a catalyst for long yen positions. With US interest rates having risen significantly versus almost all G10 countries in recent quarters, the dollar has become a carry currency. It is difficult for any currency to act as both a safe haven and carry currency, due to opposing driving forces. A rise in volatility will be a boost for the yen. Chart 17The Yen Is The Better Hedge Valuations And A Trade Idea In a report titled “A Short Note On US Dollar Valuations,” we suggested that the yen was the most undervalued G10 currency. According to our in-house PPP models, an investor who buys the yen today can expect to make 6% a year over the next decade, based on the historical correlation between valuation and subsequent currency returns (Chart 18). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As a play on rising volatility, cheaper valuations, and a positive carry, we suggest investors short CHF/JPY today, with a stop at 127, and a target of 115. Historically, these currencies have tended to move together. However, more recently, CHF has risen substantially versus JPY, suggesting some mean reversion is due (Chart 19). Chart 18The Yen Is Very Cheap Chart 19Sell CHF/JPY Housekeeping We are closing our long AUD/NZD trade for a modest profit of 2.5%. We introduced this tactical trade over 6 months ago and are now cognizant of the negative carry as global yields rise. As a reminder we usually hold tactical trades for 6 months, and cyclical trades for 6-18 months. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary The ultimate inflation anchor is unit labor costs. If relative price shocks cause employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. US unit labor costs have been rising rapidly, which indicates that US inflation is becoming pervasive and entrenched (Chart of the week). The Fed is facing an acute dilemma that it has not encountered in the last 35 years or so: It either needs to slow growth materially to contain inflation or allow inflation to proliferate. The Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from the current levels. Rapid Rises In Unit Labor Costs Entail High Inflation Bottom Line: The Fed and equity markets are on a collision course: The Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Feature In a report we published a year ago titled Riding A Tiger, we stated that “the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger… Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount.” We also contended that “in any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation… Odds are that the US will experience asset bubbles and inflation in the real economy.” Riding a tiger was indeed fun but now it is time for US policymakers to dismount. Yet, exiting the era of super easy monetary and fiscal policies will not be without costs and considerable financial market turbulence. Are the Fed and financial markets heading into a collision in the fog of inflation? Transitory Versus Persistent Inflation Chart 1US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US inflation has become broad-based.1 Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation have risen substantially (Chart 1). Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor cost are calculated as nominal wages divided by productivity (the latter is output per hour per employee). As long as unit labor costs are not rising considerably, sharp price increases in several types of goods do not entail genuine inflation and central banks should not tighten aggressively. However, when unit labor costs are escalating, odds are that higher inflation could become entrenched and persistent. The importance of wages stems from the fact that labor compensation makes up the largest share of costs for the majority of industries. Consequently, rising unit labor costs squeeze profit margins. When this transpires, businesses try to pass on rising costs to customers. Provided that robust wage growth propels consumer demand, companies often succeed in raising their prices. Chart 2US Wages Are Rising Rapidly In turn, inflation erodes the purchasing power of wages, and employees demand substantial pay raises. When revenues are strong, employers typically accommodate employees’ claims for higher compensation, and a wage-price spiral emerges. These dynamics are presently unfolding in the US. US wage growth has reached multi-decade highs of 4.5-5.5% (Chart 2). Plus, the high and climbing quit rate points to further wage acceleration (Chart 3). As US productivity cannot rise as fast as the current wage growth of 4.5-5.5% (Chart 4), the ratio of wages to productivity (unit labor costs) is escalating. Unit labor costs are rising faster than they have in the past 38-40 years. Historically, an acceleration in unit labor costs has often heralded higher inflation (Chart 5). Chart 3US Wages Will Continue Accelerating Chart 4Wage Growth Is Outpacing Productivity Gains Chart 5Rapid Rises In Unit Labor Costs Entail High Inflation The only period when US core inflation fell despite rising unit labor costs was during the second half of the 1990s (Chart 5). During this period, EM currency devaluations from China to Mexico and then to Asia unleashed the deflation tsunami in goods prices. US imports prices from Asia collapsed allowing US inflation to drift lower despite rising unit labor costs. The current backdrop is different: US import prices from Asia, including China, are rising (Chart 6). Importantly, US wage growth is presently below headline and core CPI, i.e., real wages are contracting (Chart 7). Provided US employees have experienced a decline in their purchasing power in the past 12 months, they are keen to secure substantial pay raises in the coming months. Chart 6Unlike The Late 1990s, US Import Prices From Asia Are Rising Chart 7US Real Wages Are Shrinking Employers facing strong demand cannot afford an employee exodus. Businesses will raise salaries and hike selling prices to preserve their profit margins, thereby giving rise to a wage-price spiral. Bottom Line: The ultimate inflation anchor is unit labor costs. This is why wages, more specifically unit labor costs, are the most important variable to monitor. If relative price shocks lead employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. The Fed’s Dilemma When inflation becomes pervasive and entrenched, as it is now in the US, the only way to bring it down is to slow the economy. Unless demand decelerates meaningfully, US inflation will not go away because it has already spilled over into consumer and business expectations. Even though US headline and core CPI will likely drop in the coming months, core inflation will remain well above the Fed’s target of 2% (Chart 1 above). To maintain its credibility, the Fed should hike rates continually despite the potential rollover in headline and core CPI measures. Chart 8High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months My colleague, Jonathan Laberge, Managing Editor of the Bank Credit Analyst, has quantitatively estimated that there is a almost 100% probability that in next 12 months core PCE inflation will be above 3%, and a 70% probability that it will be above 4% (Chart 8). All this means that if the Federal Reserve is serious about bringing core inflation closer to 2%, it will have to slow down the economy meaningfully. In short, the Fed cannot both achieve decent growth and bring inflation down to its 2% target in the next 1-2 years. The Fed seemed omnipotent over the past 35 years because inflation was falling or was very low. That allowed US monetary authorities during financial crises/deflationary shocks to cut rates aggressively and flood the system with liquidity. That playbook worked well in a disinflation context and the US central bank has prevented protracted debt deflation. When inflation – rather than deflation – is the problem, authorities can do little without slowing growth. In short, an inflation redux has made US policymakers’ jobs much more difficult. If the Fed tightens too much, the economy will slump. If policymakers drag their feet and do not raise interest rates rapidly and significantly, inflation will hover well above its target and inflation expectations will escalate with negative ramifications for the economy (more on this below). Bottom Line: The Fed is facing an acute dilemma. The Fed will not publicly acknowledge it, but financial markets are gradually waking up to the new reality that the era of an omnipotent Fed might be over, at least for a period of time. Why Not Allow Inflation To Proliferate? Why should authorities tighten policy and slow growth to reduce inflation? Why can’t the US operate with inflation in a range of 3.5-5%? First, there is no guarantee that core inflation will stabilize at 3.5-5% and not rise further. When higher consumer and business inflation expectations set in, they are not easily dislodged. Second, persistent inflation can damage growth itself. High price volatility increases business uncertainty as producers cannot properly plan their costs and selling prices. Higher uncertainty leads companies to abandon expansion projects and new investments. Consequently, economic growth, employment and ultimately productivity suffer. Lower productivity growth creates fertile ground for inflation to thrive. This can lead to stagflation whereby growth slows but inflation remains high. Finally, from a political perspective, inflation can be more damaging to a government’s popularity than modestly high unemployment. For example, if the unemployment rate is at 6-7%, there would be some unhappy voters, but the majority of the population would be employed and their real purchasing power would be rising. Hence, the majority of voters might be content about the incumbent government’s policies. In an inflation scenario, however, everyone would be unhappy because inflation erodes the purchasing power of household income and wealth. The point is that moderately high unemployment affects a few families who do not have jobs while inflation affects everyone. US politicians and policymakers have forgotten the perils of inflation because rapidly rising prices have not been a problem for decades. Therefore, they have erred on the side of helicopter money assuming that deflationary pressures and higher unemployment are worse than inflation. They have forgotten that inflation is not only worse for the wider population but that it could cause growth to slump resulting in stagflation: a combination of high inflation and high unemployment. Inflation has already become a political problem in the US. With income growth lagging behind inflation, household purchasing power has declined, which has fueled dissatisfaction with the current government. Biden’s popularity has tanked in the past nine months along with the rise of inflation. If inflation is not quelled by this fall, chances are that the Democrats will lose Congress to the Republicans in the midterm elections. Further, if high inflation persists in the next two years, odds of a Republican candidate winning the 2024 presidential elections will be considerable. Recognizing this, the Biden administration will not oppose the Fed’s hawkish policy for now. While we are sympathetic to the view that the Fed will ultimately not raise rates too aggressively, they have no reason not to hike and cannot afford to appear dovish at the current juncture. Even as headline and core inflation measures start falling (which is very likely in the months ahead), the Fed has no excuse to turn dovish. The rationale is that the US core inflation rate, while dropping from 5.5-6%, will still be well above the central bank’s target of 2%. In our opinion, the Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from current levels. Bottom Line: Until panic selling occurs in the equity and credit markets or the economy is materially weaker, the Fed will hike interest rates at every meeting and will start quantitative tightening soon. Thus, US bond yields and the US dollar have more upside for the time being. Overall, the Fed and equity markets are on a collision course: the Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Implications For Financial Markets Chart 9Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated As long as the Fed maintains its hawkish bias (which is very likely in the coming months), US bond yields will rise and/or the yield curve will flatten, the greenback will be firm, and stocks will struggle. The current environment will be more reminiscent of what occurred in the late 1960s than any other period of the past 40 years. In the second half of the 1960s, when US core CPI spiked, US share prices became negatively correlated with US bond yields (Chart 9). We discussed this topic at great length in a report from a year ago. Hawkish monetary policy amid the inflation overshoot means that the Fed appears to be credible, and this stance is positive for the US dollar. As soon as the Fed makes a dovish pivot however, the US dollar will tank. The basis is that by turning dovish earlier than warranted, odds are that inflation would remain well above its target, i.e., the Fed would fall behind the inflation curve. When a central bank is behind the inflation curve, the currency depreciates. Our US Equity Capitulation Indicator has fallen quite a bit but has not yet reached its 2018, 2016, 2011 and 2010 lows (Chart 10). We believe the macro backdrop is poor enough to justify a pullback on par with those selloffs (17-20% from the peak). In such an environment, EM stocks will outperform DM only if the US dollar weakens (Chart 11). Chart 10More Downside In The S&P 500? Chart 11EM Relative Equity Performance Moves With The US Dollar Chart 12Will The Current Episode Play Out Like Q4 2018? Alternatively, we might be witnessing a replay of Q4 2018 when the S&P 500 sold off hard led by tech stocks, but having underperformed earlier that year EM outperformed (Chart 12). While such a scenario is quite possible, we need to downgrade our view on the US dollar in order to upgrade EM stocks from underweight. We are not ready to do so because we believe the Fed’s hawkish bias will for now support the greenback. On the whole, we continue to recommend underweight allocations to EM equities and credit markets within their respective global portfolios. Absolute-return investors should stay cautious on EM risk assets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Please note this is the view of Emerging Markets Strategy team and does not reflect the view of other BCA services. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations