Currencies

Executive Summary KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Global financial markets appear to be moving away from inflation worries to pricing in a major growth slump. Global growth is downshifting, and financial markets have not yet priced this in. Given that the US dollar is a countercyclical currency, it will remain firm despite lower US growth and interest rate expectations. Emerging Asian currencies will drop further. A new currency trade: Go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile.   Recommendation INITIATION DATE RETURN Short KRW / Long JPY 2022-05-26   Bottom Line: Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields will likely roll over and bonds will outperform stocks in the near-term.     Global financial markets appear to be moving away from worries about inflation to pricing in a major growth slump. The recent simultaneous drop in US Treasury yields and US share prices indicate that the market theme is shifting from inflation to a growth scare. Chart 1A Sign of Peak In Bond Yields A Sign of Peak In Bond Yields A Sign of Peak In Bond Yields Interestingly, high-yielding currencies such as AUD, NZD, and CAD have recently started underperforming low-yielding JPY and CFH (Chart 1, top panel). The former are a play on global growth while the latter are vulnerable to rising US interest rates. Thus, the financial markets’ theme seems to be moving from inflation to weaker growth. The facts that this currency ratio correlates with 10-year US Treasury yields and has rolled over at its previous peaks signal that investors’ global growth concerns will likely intensify (Chart 1, top and bottom panels). As such, this currency ratio and US bond yields will continue drifting lower. Overall, the next phase of the selloff in global risk assets will likely be characterized by heightened growth worries. This phase will also mark the final chapter of this bear market. A pertinent question for investors is whether global risk assets have already priced in a global growth slump. Is A Global Slowdown Priced In? Our hunch is that the unfolding global economic slowdown is not yet fully priced in global financial markets. Chart 2Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink Global Export Volumes Are Set To Shrink In the near term, global share prices will continue to falter and odds are rising that US bond yields are putting in a major top. In short, global stocks will underperform US bonds, and the USD dollar will remain firm: First, global trade volumes are heading into contraction (Chart 2). Global export volumes are set to contract as US and European demand for goods ex-autos shrinks following the pandemic binge. Meanwhile, China’s recovery has been delayed to Q3. We discussed the reasons why we expect global exports will contract in H2 2022 in our April 21 report. Declining global trade volumes will support the greenback in the near term because the broad trade-weighted US dollar does well when global growth is weakening. Besides, US dollar liquidity is rapidly decelerating, which is also positive for the broad-trade weighted US dollar (the latter is shown inverted in Chart 3). Second, US rail carload is contracting, pointing to weakening growth in America (Chart 4). Chart 3No Sign Of Reversal In Trade-Weighted USD No Sign Of Reversal In Trade-Weighted USD No Sign Of Reversal In Trade-Weighted USD Chart 4US Growth Is Downshifting US Growth Is Downshifting US Growth Is Downshifting Related Report  Emerging Markets StrategyA Whiff Of Stagflation? This does not mean that a US recession is imminent. Yet, as we discussed in past reports US corporate profits can contract modestly even if GDP slows but does not contract. Third, US EPS expectations have not yet been downgraded and 12-month forward EPS growth expectations are at about 10% (Chart 5). Similarly, although our forward-looking indicator for EM EPS points to a contraction 12-month forward EPS growth expectations are still at 10% (Chart 6). Chart 5US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded US EPS Expectations Have Not Yet Been Downgraded Chart 6EM EPS Are Set To Contract EM EPS Are Set To Contract EM EPS Are Set To Contract We expect slower top line growth and shrinking profit margins to cause US and EM corporate profits to contract by about 5% and 10-15%, respectively, in the next 12 months. In brief, neither US nor EM stocks have priced in negative profit growth. Fourth, Chart 7 illustrates that slowing global broad money growth is typically associated with a compression in the P/E ratio of global equities. As of now, there are no sign of reversal in global broad money growth and equity multiples. Chart 7Will Global Equity Multiple Compression Continue? Will Global Equity Multiple Compression Continue? Will Global Equity Multiple Compression Continue? Chart 8US Stocks Are Set To Underperform US Treasurys In Near Term US Stocks Are Set To Underperform US Treasurys In Near Term US Stocks Are Set To Underperform US Treasurys In Near Term Finally, sentiment towards US stocks is very elevated relative to sentiment towards US Treasurys (Chart 8, top panel). Yet, the composite momentum indicator for the US stock-to-bond ratio is breaking below the zero line (Chart 8, bottom panel). This breakdown warns of a period of equity underperformance versus US Treasurys, which would be consistent with pricing in a material economic slowdown. As US growth slows, will the Fed back off from its hawkish rhetoric? Yes, it will tone down its hawkishness at a certain point – but it will not do so immediately. The basis is that even though core US inflation will roll over, it will remain well above 4% versus the Fed’s 2% target. Importantly, wages are a lagging variable, and they will surprise to the upside in the near-term amid tight labor market conditions. This will lead the Fed to err on the hawkish side to manage upside risks to inflation and inflation expectations. All in all, the Fed is not about to do a policy U-turn in the near term. Therefore, we maintain our view that the Fed and stock markets remain on a collision course. Bottom Line: Global growth is downshifting, and financial markets have not yet priced this in. As a result, US bond yields will likely roll over and bonds will outperform stocks in the near term. The US dollar as a countercyclical currency will remain firm despite lower US growth and interest rate expectations. Emerging Asian Currencies Will Depreciate Further Asian export volumes will contract in H2 2022. This is negative for emerging Asian currencies. Chart 9Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian Currencies And Global Manufacturing Cycle Emerging Asian exchange rates correlate with global trade and global manufacturing cycles, and these currencies will depreciate as global consumer goods demand shrinks (Chart 9). We use an equally-weighted average of KRW, TWD, SGD, THB, PHP and MYR versus the USD to measure the performance of emerging Asian currencies. We exclude the CNY and JPY as they exhibit different dynamics. Chinese imports of various goods and commodities were already contracting in March, prior to the broadening of mainland lockdowns (Chart 10). Weak demand from China will weight on other Asian economies. The CNY is likely to weaken a bit more versus the US dollar due to the challenges facing the Chinese economy. This will reinforce further depreciation in emerging Asian currencies. Relative share prices of global cyclicals versus defensives also point to more downside in emerging Asian currencies (Chart 11). Chart 10Chinese Imports Were Contracting Prior Lockdowns Chinese Imports Were Contracting Prior Lockdowns Chinese Imports Were Contracting Prior Lockdowns Chart 11Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio Emerging Asian Currencies Correlate With Global Cyclicals-Defensives Equity Ratio   Bottom Line: An impending contraction in Asian export shipments is negative for emerging Asian currencies. A New Trade: Long Japanese Yen / Short Korean Won One way to play the global trade contraction and peak in US interest rate expectations themes is to go long the JPY / short the KRW: The Korean won typically depreciates versus the Japanese yen when (1) the global manufacturing cycle enters a downtrend and (2) US bond yields decline (Chart 12). These two macro forces are about to transpire and will help the JPY to outperform the KRW. Chart 12KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields KRW vs JPY: A Play On Global Slowdown And Lower US Bond Yields Chart 13Trade-Weighted Yen Is At Its Historic Lows Trade-Weighted Yen Is At Its Historic Lows Trade-Weighted Yen Is At Its Historic Lows The Japanese yen has already depreciated significantly versus both the USD and the Korean won. In fact, the trade-weighted yen is close to its historic lows (Chart 13). In addition, investors are very short the yen (Chart 14). The overhang of short positions could cause a violent reversal in the JPY/USD exchange rate.   The Japanese yen is extremely cheap according to the real effective exchange rate based on unit labor costs (Chart 15, top panel). By that same measure, the Korean won is not cheap (Chart 15, bottom panel). Chart 14Investors Are Very Short Yen Investors Are Very Short Yen Investors Are Very Short Yen Chart 15The Yen Is Much Cheaper Than The Korean Won The Yen Is Much Cheaper Than The Korean Won The Yen Is Much Cheaper Than The Korean Won   Bottom Line: We recommend that investors go long the JPY versus the KRW. The global macro outlook, currency valuations and technicals suggest that this trade offers a good risk-reward profile. On February 2, 2022, we booked profits on our short KRW/long USD position, which we initiated on March 25, 2021. Investment Recommendations Global equity and credit investors should stay defensive. EM share prices and credit markets (USD bonds) are not yet out of the woods. US bond yields are likely peaking. Favor bonds over stocks within both global and EM balanced portfolios. Although the US dollar’s bull market is advanced, a final upleg is likely. Stay short the following EM currencies versus the US dollar: ZAR, PLN, HUF, COP, PEN, PHP and IDR. Consistently, emerging Asian currencies have more downside. A major buying opportunity in EM local currency bonds will emerge once the US dollar begins its descent.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Villains Still Lurking Villains Still Lurking Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets.      After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Don’t Be A Hero Don’t Be A Hero Chart 2Low-Income Households Are At Risk Don’t Be A Hero Don’t Be A Hero Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 4European Inflation Is Energy inflation European Inflation Is Energy inflation European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised Fed Put Not Exercised Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chinese Growth Problems Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies.  An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Brewing EM Troubles Brewing EM Troubles Chart 12Cyclicals At Risk From China Cyclicals At Risk From China Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium The Euro's Large Risk Premium The Euro's Large Risk Premium Chart 14The Over Extended Dollar The Over Extended Dollar The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022.  We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report  European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks.    Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Image Chart 4Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Image Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included ... Small Business Owners Included ... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Image Chart 9When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock   Image Chart 20B... But They Like Bonds Even Less ... But They Like Bonds Even Less ... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Image A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Special Trade Recommendations Current MacroQuant Model Scores Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A

Listen to a short summary of this report.     Executive Summary EUR/JPY And The DXY: Unsustainable Gap EUR/JPY And The DXY: Unsustainable Gap EUR/JPY And The DXY: Unsustainable Gap Three interrelated themes are likely to play out by the end of 2022 – peak Fed hawkishness, continued central bank convergence, and nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet through a short EUR/JPY trade, a corresponding play on the second theme. Betting on nascent green shoots in economic growth can be expressed via a long Aussie position, or more prudently, a short CHF/SEK bet. We are long a CAD and NOK basket against the RUB, a play on an eventual recovery in oil demand, and the premium that these blends will continue to command relative to Russian oil. Finally, most of our trades remain at the crosses due to elevated FX volatility which has boosted safe-haven demand for the dollar. The admission of Sweden and Finland into NATO could increases the risk of miscalculation on the part of Russia, which will continue to prop near-term safe-haven demand for the dollar. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 133.28 2022-05-12 -0.73 Bottom Line: Continue to focus on relative value trades at the crosses, until signs emerge that FX volatility is peaking, which will be more conducive for direct USD bets. Feature Chart 1Dollar Capitulation Occurs At Record Valuation And A Record Deficit Dollar Capitulation Occurs At Record Valuation And A Record Deficit Dollar Capitulation Occurs At Record Valuation And A Record Deficit Last week’s report focused on the key reasons why longer-term investors should begin to fade dollar strength. For one, the dollar already imbeds a hefty safe-haven premium. This premium manifests itself in an overvalued exchange rate (Chart 1). A simple PPP model shows that the dollar is overvalued by 27%. This is higher than the peak in the US dollar which preceded the bear market that began in the early 2000s. While valuations tend to matter little until they trigger a tipping point, such an inflection point could be around the corner. One catalyst has been the widening trade deficit which needs to be financed via foreign capital inflows. The US trade deficit continues to deteriorate, hitting a record low of $109.8bn in March. Over the last few years, it has become increasingly difficult to fund this widening trade deficit through foreign purchases of US Treasuries. That said, FX markets are likely to focus on three interrelated themes in the near term – peak Fed hawkishness, continued central bank convergence, and the potential for nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet with a short EUR/JPY trade, a corresponding play on the second theme. In the next few sections, we go through a few trades that would benefit from these themes.   Short EUR/JPY: A Defensive Play Most of our trades in the portfolio are pro-risk.  As such, a short EUR/JPY position acts as an attractive hedge in the near term. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate, but an unusually wide gap has opened up (Chart 2). In our view, this suggests that the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, as we witnessed on Wednesday, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that this cross is stretched on a longer-term time horizon. First, the cross is expensive on a PPP basis. Chart 3 shows that EUR/JPY usually peaks when the real effective exchange rate is 1.5 standard deviations above its long-term mean. Today’s valuation pins it close to that, among the highest levels since the 1980s. Standard economic theory suggests that a reversal in the cross will be warranted to realign euro area competitiveness relative to Japan. Chart 2EUR/JPY And The DXY: Unsustainable Gap EUR/JPY And The DXY: Unsustainable Gap EUR/JPY And The DXY: Unsustainable Gap Chart 3EUR/JPY Is Not Cheap EUR/JPY Is Not Cheap EUR/JPY Is Not Cheap Meanwhile, there is a case to be made that an expensive EUR/JPY exchange rate is already affecting relative competitiveness. European exports are relapsing relative to those in Japan, which usually ensues after a period of euro-yen strength. Case in point: German factory orders are already contracting, while machinery orders in Japan remain relatively robust (Chart 4). Second, the European Central Bank has been relatively hawkish, vis-à-vis the Bank of Japan. The yield on December 2022 Euribor contracts is 78bps above the TIBOR equivalent, suggesting the ECB will hike rates 4-5 times this year versus the BoJ. Granted, inflation is overshooting in Europe relative to Japan (Chart 5). But as we have been witnessing around the world from the UK to Canada, and all the way to Australia, rising inflation is a global problem. If it persists, it will also begin to meaningfully show up in the Japanese numbers. This will nudge the BoJ away from the ultra-dovish camp.  More likely, inflation will moderate, which will allow the ECB to dial back its hawkish rhetoric. Chart 4Europe Is Losing Competitiveness To Japan Europe Is Losing Competitiveness To Japan Europe Is Losing Competitiveness To Japan Chart 5Eurozone Inflation Could Subside In The Coming Months Eurozone Inflation Could Subside In The Coming Months Eurozone Inflation Could Subside In The Coming Months Even if inflation moderates in the eurozone, short-term real rates will remain deeply negative compared to Japan. This will be a significant drag for relative fixed income flows and the currency (Chart 6). At the same time, higher inflation in Europe also suggests the fair value for EUR/JPY should continue its structural downtrend. Chart 6Real Rates Are Very Low In The Eurozone Real Rates Are Very Low In The Eurozone Real Rates Are Very Low In The Eurozone Third, oil price volatility will remain high in the near term but will subside longer term. We are cognizant of the fact that, our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium in oil to increase in the near term. When rising oil coincides with rebounding economic activity, the yen tends to lag as a defensive currency (Chart 7). This time around, the premium in energy markets has come from a cutoff in Russian supplies. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 8). This has boosted EUR/JPY and is a risk to a short position. Chart 7EUR/JPY Tracks Oil EUR/JPY Tracks Oil EUR/JPY Tracks Oil Chart 8Japan Will Accelerate A Shift From Fossil Fuels Japan Will Accelerate A Shift From Fossil Fuels Japan Will Accelerate A Shift From Fossil Fuels That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent are collapsing (Chart 9). The Japanese have already ramped up nuclear power production, reducing their dependence on fossil fuels (Chart 10). That will be a welcome fillip for the Japanese trade balance. In a nutshell, a lot of bad news is already priced in the yen. As such, it has become an attractive hedge. Asian clients not willing to short the euro can short CNY/JPY as a close proxy. Interestingly, CNY/JPY has made a classic double-top and could meaningfully depreciate from current levels (Chart 11), along with EUR/JPY. Chart 9The European And Asian Natgas Premium Is Deflating The European And Asian Natgas Premium Is Deflating The European And Asian Natgas Premium Is Deflating Chart 10A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? Chart 11CNY/JPY: A Double Top? CNY/JPY: A Double Top? CNY/JPY: A Double Top? Short CHF/JPY: Still Attractive, But Taking Profits We also played a long yen leg via a short CHF position but our trailing stop was triggered this week at 130 for a profit of 3.74%. While we believe the cross still faces meaningful downside, we will opportunistically look to sell CHF/JPY again at 135. First, historically, CHF/JPY has inversely tracked the inflation profiles between Switzerland and Japan. Given the collapse in the yen, and much higher Swiss inflation, CHF/JPY has become incrementally more expensive, especially relative to history (Chart 12). To realign competitiveness, the cross should depreciate. Second, from a technical perspective, CHF/JPY is in a classic double-top formation (Chart 13), akin to CNY/JPY. This suggests the safe-haven premium is much higher in the franc than it is in the yen.    Chart 12Swiss Inflation Is Lowering CHF"s Puchasing Power Swiss Inflation Is Lowering CHF"s Puchasing Power Swiss Inflation Is Lowering CHF"s Puchasing Power Chart 13CHF/JPY: Look To Go Short Again CHF/JPY: Look To Go Short Again CHF/JPY: Look To Go Short Again The key risk to this trade is that the Swiss equity market is more defensive relative to Japanese bourses. As such, the hefty safe-haven premium in the franc could persist (Chart 14), pushing the cross to our initial entry short point at 135. Chart 14Swiss Equities Could See Inflows Near Term Swiss Equities Could See Inflows Near Term Swiss Equities Could See Inflows Near Term Short CHF/SEK: A Play On The Riksbank’s U-Turn Chart 15Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Last month, we argued that the dip in the Swedish krona had already priced a recession in the domestic economy. Meanwhile, with a mandate of price stability, we argued the Riksbank will have no choice but to turn more hawkish or lose credibility. As a play on this trend, we recommended going long the SEK relative to the CHF. In a major policy U-turn, the Riksbank raised rates and announced a faster pace of balance-sheet reduction. Most of the arguments made in the original report remain valid, so we will not revisit them here. The one point we will stress is that Sweden’s small open economy makes the SEK very sensitive to global economic conditions. One benefit of a short CHF/SEK position is that while value has been outperforming growth during this selloff, CHF/SEK remains strong which is a departure from the traditional relationship (Chart 15). Ergo, a major safety discount is imbedded in the SEK. Related Report  Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar Sweden’s bourse is heavy in cyclicals, with large overweight positions in financials and industrials, that will benefit from a renewed capital spending cycle, and higher global rates. Meanwhile, the outperformance of value during a market riot point suggests a change in market leadership could be underway, even if bond yields temporarily crater. The krona remains vulnerable to geopolitical risk, especially if Russia retaliates against Sweden and Finland joining NATO.  So far, Russia’s response has been muted. As such, while this pro-cyclical trade faces near-term risk, it remains a safer way, in our view, to play SEK strength. Long AUD: Bet On An Eventual China Rebound Chart 16The AUD And China The AUD And China The AUD And China We will be discussing Australia in an in-depth report next week, so we will keep our comments brief this week. What we will say is that the Aussie is one of the best candidates to play a rebound in global growth, given that it sits near the epicenter of where that growth will likely emanate from – China (Chart 16). Right now, the picture is not pretty, but it is always dark before dawn. Stay tuned. Long (CAD+NOK)/RUB: A Relative Value Play As many countries reroute their oil supplies from Russia to other countries, Canada and Norway could stand to benefit from a relative perspective. Understandably, many clients might not be able to trade the RUB, so we are filing this trade under speculative. First, both Brent and Western Canadian Select oil are trading at a significant premium to the Urals blend, which is likely to be sustained in the next 6 months. This will benefit NOK and CAD, relative to the ruble (Chart 17). Chart 17CAD And NOK Will Benefit From Premium Oil CAD And NOK Will Benefit From Premium Oil CAD And NOK Will Benefit From Premium Oil Second, from an FX point of view, Russia faces the trilemma of the impossible trinity – having decided to limit the free flow of capital, it has chosen independent monetary policy and managing the exchange rate. This will come at a cost, however: As the economy comes grinding to a halt and inflation surges, interest rates will have to stay high to maintain currency stability. This will crush the domestic economy for years to come. Luckily, Russia has a healthy current account surplus, but as production in Canada and Norway improve to offset embargoes on Russian crude, this will also boost their external balance. Long EUR/GBP: The Euro Is More Priced For A Recession We have discussed at length the rationale behind our long EUR/GBP position, so we will not reiterate the arguments here. Our Global Fixed Income colleagues upgraded Gilts to overweight last week, in line with expectations that markets will continue pricing a dovish tilt from the BoE. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. As such, if interest rates in the UK continue to fall relative to those in the eurozone, EUR/GBP will benefit (Chart 18). Chart 18EUR/GBP Has Upside EUR/GBP Has Upside EUR/GBP Has Upside 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

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom The UK economic outlook has greatly deteriorated. Weak global growth and punishing energy inflation will cause activity to contract over the next 12 months. Cost-push pressures will drag inflation above 10% in 2022. Moreover, demand-pull inflation highlights problems with the supply-side of the economy. UK yields have downside relative to those in the Euro Area. GBP/USD will bottom once global stock prices find a floor. EUR/GBP possesses more upside. UK stocks will enjoy a structural tailwind relative to their Eurozone counterparts as a result of a secular bull market in commodity prices. Nonetheless, UK equities are likely to underperform in the second half of 2022. UK small-cap stocks are massively oversold compared to large-cap shares; however, a peak in energy inflation must take place for small-cap equities to stage a rebound. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Overweight UK Gilts Within European Fixed-Income Portfolios 05/16/2022   Cyclical Buy European Healthcare Equities / Sell UK Healthcare Equities 05/16/2022   Tactical Buy European Financials Equities / Sell UK Financials Equities 05/16/2022   Tactical Bottom Line: British Gilts will outperform because of the weakness in UK economic activity, but the trade-weighted pound will remain under pressure. The performance of UK large-cap names is mostly independent from the state of the British economy. The commodity secular bull market will create a potent tailwind for this market. However, a better entry point lies ahead.       The Bank of England’s (BoE) latest policy meeting was a cold shower for market participants and their aggressive interest rate pricing in the SONIA curve. Money markets expected a peak in the Bank Rate of 2.7% in 2023, but the BoE’s new Market Participants Survey is calling for it to peak at 1.75% before easing off to 1.5% in 2024. The UK economy is in trouble. Inflation is high and broad-based, which explains why investors are pricing in such an aggressive path for the Bank Rate. Yet, economic activity is weakening and could even contract in early 2023. The BoE clearly puts more weight on growth than investors do. What are the implications of the inflation, growth, and policy outlook for British assets? BCA has upgraded its view on UK bonds to overweight within global fixed income portfolios. We expect more softness in the pound versus the euro. UK large-cap stocks will continue to trade in line with energy dynamics, which means it is still too early to buy British small-cap equities. In the meantime, UK financial and healthcare names will underperform their Euro Area counterparts. Growth To Weaken Further The -0.1% month-over-month GDP contraction in March underscores that UK economic activity has already decelerated sharply. However, the deterioration is only starting. Most sectors of the economy show ominous signs for the quarters ahead. Consumer Sector The biggest hurdle facing UK consumers, like most of their European neighbors, is the surge in inflation, particularly energy and food prices. Safety nets are looser than on the continent, and UK households’ real disposable income are contracting sharply. The impact of this weakening of activity is already visible. UK consumer confidence is falling in line with the knock to real disposable income (Chart 1, top panel). Moreover, real retail sales have already slowed sharply, and the BRC Like-For-Like Retail Sales measure is contracting on an annual basis (Chart 1, bottom panel). As a result, the outlook for consumption is worsening. Ofgem, the UK gas and electricity market regulator, lifted its energy price cap by 54% on April 1st and plans to increase it again by an expected 40% in October. Consequently, the BoE anticipates the share of households’ disposable income spent on energy to hit 7.7% by the end of the year — its highest level since the early 1980s (Chart 2). Chart 1Falling Real Incomes Hurt Falling Real Incomes Hurt Falling Real Incomes Hurt Chart 2Intensifying Energy Drag Intensifying Energy Drag Intensifying Energy Drag The savings cushion developed during the pandemic will not be enough to prevent weaker retail sales. More than 40% of households plan to dip into their existing savings and curtail their savings rate; however, UK excess savings skew heavily toward the richer households. Poorer households with low savings are the ones who spend the largest share of their income on energy (Chart 3), and they are also the ones with a higher marginal propensity to consume. Thus, the knock to these households portends further weakness in consumption volumes. Chart 3The Poor Are Hit Harder Is UK Stagflation Priced In? Is UK Stagflation Priced In? Chart 4No Salvation From Housing No Salvation From Housing No Salvation From Housing Housing is unlikely to save the day. While house prices and housing transactions are robust (Chart 4, top panel), mortgage approvals are declining rapidly and average sales per chartered surveyors are also softening (Chart 4, bottom panels), which suggests housing activity will slow. Rising mortgage rates are a problem. Since January, the quoted rates on mortgages with 90% LTV and 75% LTV are up 65bps and 70bps, respectively, which is hurting housing marginal demand. Moreover, 20% of the UK’s mortgage stock carries variable rates, which further hurts aggregate demand. Business Sector The business sector is also feeling the crunch from rapidly rising energy and input costs. It also dreads the deterioration in consumer sentiment and its implication for future final demand. Chart 5Dwindling Capex Outlook Dwindling Capex Outlook Dwindling Capex Outlook Business confidence is falling abruptly. The CBI Inquiry Business Optimism measure has fallen to its lowest level since the beginning of the pandemic in 2020, when the UK GDP was contracting at a 21% annualized rate (Chart 5). Unsurprisingly, the collapse in business confidence prompted a rapid slowdown in CAPEX. The BoE’s Agents Survey reports that 40% of UK firms have unsustainably low profit margins because of rising input prices and partial pass-through. As a result of financial stress, further capex weakness is likely in the coming quarters. The impact on overall activity of these expanding worries is evident. UK industrial production has slowed very sharply and is now a meager 0.7% on an annual basis. The situation will degrade. Export growth remains strong, which is helping the business sector; however, the rapid slowdown in global industrial production indicates that UK exports will follow suit (Chart 5, second panel). This will have a knock-on effect on corporate profits (Chart 5, bottom panel), which will depress capex further. Other Considerations Chart 6No Offset From The Government No Offset From The Government No Offset From The Government The problems of the private sector may be encapsulated in one indicator. After a surge that boosted GDP, the UK’s nonfinancial private sector’s credit impulse is rapidly contracting (Chart 6), which confirms that risks to activity are building. The public sector will not provide an offset. According to the IMF Fiscal Monitor’s projections, the UK’s fiscal thrust will equal -3.3% of GDP in 2022 and -1.4% in 2023, even after the small giveaways from Chancellor Rishi Sunak’s Spring Statement (Chart 6, bottom panel). Together, these developments confirm our view that UK GDP may also flirt with a recession in the coming 12 months. Bottom Line: The UK economy is facing potent headwinds and activity is set to contract over the coming quarters. Surging energy costs are hurting household consumption and businesses are cutting investment. This time around, government spending is unlikely to come to the rescue, at least not until further pain is inflicted on the UK’s private sector. The BoE expects output to contract in early 2023, with which we agree. Inflation: The Worst Of Both Worlds UK headline inflation is likely to move into double digits territory before year-end. Worrisomely, it will also be more stubborn than that of the Eurozone, because it goes beyond higher food and energy input costs. Essentially, the UK suffers from both the cost-push inflation plaguing the rest of Europe and the demand-pull inflation witnessed in the US. Chart 7Continued Pass-Through Is UK Stagflation Priced In? Is UK Stagflation Priced In? The UK’s cost-push inflation will worsen in the second half of the year and could lift headline CPI above 10% by Q4 2022. Its main driver will be the Ofgem’s second energy cap increase scheduled for October, which is expected to increase household energy costs by 40%. Companies will also try to pass through a greater proportion of their rising costs to their consumers to protect their depleted margins. So far, the BoE’s Agents Survey reveals that on average, UK firms have passed through 80% of their non-labor input cost increases (Chart 7, top panel). In all the sectors surveyed, expected price increases are set to accelerate compared to the past 12 month and may even reach 14% in the manufacturing sector and 8% in the consumer goods sector (Chart 7, bottom panel). Demand-pull inflation is also present in the UK, unlike the rest of Europe, with core CPI at 5.7%, high service inflation, and rapidly rising wage growth. The key problem is an overheating labor market exacerbated by labor supply problems. By the end of 2021, the UK recorded 600 thousand inactive people more than before the pandemic, or individuals who are of working age but outside of the labor force and not seeking a job. This has compressed the labor participation rate to 63%, or the lowest level since the 2011-2012 period (Chart 8). So far, not even rapid wage gains have incentivized these persons to seek employment. The impact of Brexit further curtails the supply of labor. Since the pandemic began, the size of the working age population has decreased by 100 thousand as EU citizens have moved back home (Chart 8, second panel). Labor demand, however, is not weak. Job vacancies have surged to an all-time high of 1.3 million, or a ratio of one job vacancy per unemployed worker. Moreover, according to the BoE’s Agents Survey, the proportion of firms reporting recruitment difficulties is extremely elevated (Chart 8, third panel). As a result of weak labor supply but strong labor demand, wages are rising rapidly (Chart 8, bottom panel), with the KPMG/REC Indicator of pay higher than 6%. Chart 8Labor Market Tightness Labor Market Tightness Labor Market Tightness Chart 9Poor Productivity Weighs On Trend GDP Poor Productivity Weighs On Trend GDP Poor Productivity Weighs On Trend GDP Rapidly increasing wages and underlying inflation are indicative of a greater malaise. UK GDP is still 3.6% below its pre-COVID trend, while US GDP has already moved past its previous peak. Yet, wages and underlying inflation are just as strong in both economies. This suggests that the UK trend GDP has slowed more than in the US and that aggregate demand is colliding more rapidly with the constraint created by a weaker potential GDP. Labor supply is not the only culprit behind the slowdown in UK’s trend GDP. Since Brexit, UK capex has been particularly weak, which has depressed productivity growth and suppressed trend GDP further (Chart 9). Bottom Line: The BoE expects UK headline CPI inflation to move above 10% before the end of the year. We agree with this assessment. Cost-push inflation will remain strong in response to additional increases in regulated energy prices this fall and greater pass-through from businesses. Meanwhile, the labor market is overheated because of weak labor supply and surging job vacancies. The UK core inflation is likely to be sticky as Brexit weighs on the country’s trend GDP, which causes aggregate demand to surpass aggregate supply easily. Investment Implications The investment implications of the UK’s weak growth and strong inflation outlook are far reaching. Fixed Income Implications BCA’s Global Fixed Income Strategy service upgraded UK government bonds to overweight from underweight in their global fixed income portfolios. We heed this message and move to overweight UK Gilts relative to German Bunds within European fixed income portfolios. Chart 10The BoE's Dovish Justification The BoE's Dovish Justification The BoE's Dovish Justification The BoE’s forecast calls for a deeply negative output gap as well as a rising rate of unemployment in 2023 and 2024. According to the BoE’s model, these dynamics will weigh on headline CPI next year (Chart 10). We take the BoE at its word when it communicated a gentler pace of rate hikes than was anticipated by the SONIA curve. The BoE believes that the weakness in the UK’s trend GDP growth weighs on the country’s neutral rate of interest. Thus, there is a limited scope before higher interest rates hurt economic activity. Since the BoE already foresees a poor growth outcome and weaker inflation next year, this view of the neutral rate logically results in a shallow path of interest rate increases. In other words, the BoE is not the Fed. This view prompts our fixed income colleagues to expect the SONIA curve to move toward the gentler rhythm of interest rate hikes proposed by the BoE. As a corollary, it implies that Gilt yields have more downside. More specifically, BCA sees room for UK-German yields spreads to narrow. Investors have expected the BoE to be significantly more hawkish than the European Central Bank (ECB), and a partial convergence in expected interest rate paths is likely. Moreover, UK yields have a higher beta than German ones. As a result, the current wave of risk aversion driven by global growth fears should cause an outperformance of UK government bonds compared to German ones. Currency Market Implications The outlook for GBP/USD depends on the evolution of overall market conditions. If risk assets remain under pressure, so will Cable. Chart 11Cable And EM Stocks Cable And EM Stocks Cable And EM Stocks A durable bottom in GBP/USD will coincide with a rebound in EM equities (Chart 11). The correlation between these two assets most likely reflects the UK’s current account deficit of 2.8% of GDP in 2021. Large external financing needs render the currency very sensitive to global liquidity conditions and thus, to the dollar’s trend and global risk aversion, as is the case with EM assets. Peter Berezin, BCA Chief Global Strategist, expects global stocks to rebound in the near future, which will lift EM equities in the process. Interestingly, GBP/USD does not correlate with the relative performance of EM shares. Thus, a rebound in Cable does not contradict BCA’s Emerging Market Strategy service’s view that EM stocks are likely to underperform further in the coming months. Chart 12A Big Handicap For the GBP vs the EUR A Big Handicap For the GBP vs the EUR A Big Handicap For the GBP vs the EUR BCA’s Foreign Exchange strategy team sees further upside in EUR/GBP, toward the 0.9 level. 2-year yield differentials between the UK and Germany are likely to narrow in response to the downgrade of the SONIA curve. Importantly, the wide UK current account deficit necessitates higher real interest rates to prop the pound against the euro because the Eurozone current account surplus stands at 2.3% of GDP. However, neither the 2-year nor 10-year real rates are higher in the UK than they are in the Euro Area (Chart 12). Additionally, even the nominal yield premium of UK bonds vanishes once they are hedged into euros. UK hedged 2-year bonds yield 50bps less than their German counterparts, and 10-year Gilts offer 80bps less than Bunds, which limits continental inflows into the UK. Equity Market Implications UK stocks are pro-cyclical, and their absolute performance will bottom in tandem with global equities. The near-term outlook for global equities remains clouded by the confluence of global growth fears, a weaker CNY, and tighter monetary policy around the world. Meanwhile, UK stocks are very cheap, trading at a forward P/E ratio of 11. They are tactically oversold and are lagging forward earnings (Chart 13). Relative to global equities, the performance of UK stocks will continue to track that of global energy firms compared to the broad market. The heavy exposure of UK large-cap indices to oil and gas stocks has been a major asset since energy shares have become market darlings (Chart 14). Chart 13UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom UK Stocks Are Close To A Bottom Chart 14UK Large-Caps Are About Oil UK Large-Caps Are About Oil UK Large-Caps Are About Oil At the time of writing, Sweden and Finland have yet to officialize their membership application to NATO, but BCA’s Geopolitical Strategy team assigns a high probability to this outcome. Russia will not stand idly by, especially as the EU threatens to cut their oil imports. Consequently, a deeper energy embargo is increasingly likely, which should prompt a temporary but violent rally in oil and natural gas prices. This process should sustain a few more weeks of outperformance from UK large-cap shares relative to the rest of the world. Chart 15The UK vs The Eurozone: Cheap But Overbought The UK vs The Eurozone: Cheap But Overbought The UK vs The Eurozone: Cheap But Overbought Structurally, UK equities are likely to remain well supported. A pullback in relative performance later this year is possible once oil prices ease off as BCA’s Commodity and Energy team expects. However, the oil market will stay tight for years to come because of the investment dearth observed since 2014-2015, when OPEC 2.0 started its market-share war. According to Bob Ryan, BCA’s Chief Commodity Strategist, it will take years of high returns in the sector to attract the capital needed to lift energy capex enough to line up supply with demand. Thus, energy remains a structurally favored sector, which will boost the cheap UK market’s appeal. UK stocks enjoy a structural tailwind relative to Euro Area shares. They remain cheap, because they still trade at a significant historical discount (Chart 15). Moreover, relative earnings are moving decisively in favor of UK stocks, something that is unlikely to change, even if the UK economy contracts. Ultimately, UK large-cap names derive the bulk of their profits from overseas and the structural tailwind of a secular commodity bull market will continue to assert itself on relative profits. Nevertheless, UK shares have also become extremely overbought, which raises the risk of a pullback in the second half of the 2022 (Chart 15, third and fourth panel). The recent outperformance of UK stocks relative to those of the Eurozone has been larger than what sectoral biases explain. An equal-sector weights version of the UK MSCI has outperformed a similarly constructed Euro Area index by 9.6% year-to-date. Chart 16Waiting For Catalysts To A Eurozone Rebound Waiting For Catalysts To A Eurozone Rebound Waiting For Catalysts To A Eurozone Rebound A tactical rectification of the overbought conditions in the performance of UK equities relative to those of the Euro Area will require an ebbing of stagflation fears in the Euro Area (Chart 16, top panel). This implies that investors looking to buy Eurozone equities are waiting for a stabilization in the energy market (that is, waiting for clarity about Sweden’s and Finland’s NATO decision as well as Russia’s response). It also means that the Chinese economy must stabilize, since Eurozone equities are more sensitive to the evolution of the Chinese credit impulse than UK ones (Chart 16, second panel). Nonetheless, BCA’s Global Fixed Income Strategy team’s view on UK-German spreads is consistent with an eventual tactical pull back in the relative performance of UK stocks vis-à-vis Euro Area ones (Chart 16, bottom panel). Two pair trades make attractive vehicles to bet on an underperformance of UK stocks relative to those of the Euro Area in the second half of 2022. The first one is to sell UK financials at the expense of Euro Area financials. Historically, a decline in UK Gilt yields relative to their German equivalent strongly correlates with an underperformance of UK financials (Chart 17). The second one is to sell UK healthcare names relative to those in the Eurozone. The relative performance of healthcare shares has greatly outpaced relative earnings and is now hitting a critical resistance level (Chart 18). Moreover, UK healthcare firms are exceptionally overbought relative to their Euro Area competitors. Importantly, those two trades display little correlation to the broad market trend. Chart 17Challenges To UK Financials Challenges To UK Financials Challenges To UK Financials Chart 18UK Healthcare: Running Ahead Of Itself UK Healthcare: Running Ahead Of Itself UK Healthcare: Running Ahead Of Itself Finally, UK small-cap stocks are becoming attractive relative to their large-cap counterparts, although the timing remains risky. Unlike the internationally focused large-cap indices, small-cap shares are a direct bet on the health of the UK domestic economy. Hence, small- and mid-cap names have massively underperformed the FTSE-100 as market participants sniffed out the poor outlook for UK economic activity (Chart 19). They are now extremely oversold relative to large-cap names and their overvaluation has been corrected. The main problem with small-cap shares is the lack of a catalyst to rectify their oversold conditions. The most likely candidate for such a reversal would be a peak in energy inflation, considering it stands at the crux of the headwinds that UK consumption and growth face. However, energy CPI will not peak until later this fall and thus, the pain on UK households will build until then. As a result, wait for a clear sign that energy inflation recedes before entering a long UK small-cap / short UK large-cap contrarian trade (Chart 20). Chart 19Bombed Out Small-Caps... Bombed Out Small-Caps... Bombed Out Small-Caps... Chart 20…Need A Peak In Energy Inflation ...Need A Peak In Energy Inflation ...Need A Peak In Energy Inflation Bottom Line: In line with our expectations that UK growth will worsen significantly in the quarters ahead, we follow the BCA Global Fixed Income team and move to overweight UK government bonds within European fixed income portfolios. While we expect GBP/USD will bottom once global risk assets find a floor, BCA’s Foreign Exchange Strategy team also anticipates Sterling to depreciate further relative to the euro. Because of their large energy and materials exposure, UK large-cap equities will enjoy a structural outperformance relative to Euro Area large-cap indices on the back of a secular bull market in commodities. However, a temporary pullback in the UK’s relative performance is likely in the second half of 2022. Selling UK financials and UK healthcare stocks relative to their Eurozone counterparts offers a compelling approach to implement this view. Finally, UK small-caps are oversold relative to large-caps, but we recommend investors wait until energy CPI peaks when a relative rebound may emerge.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.     Executive Summary The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107       Short EUR/JPY 2022-05-12 133.278 120 137       Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon.       Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar Chart 2The Fed And The Dollar The Fed And The Dollar The Fed And The Dollar Chart 3The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? How Sustainable Is The Breakout How Sustainable Is The Breakout The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106.  Euro: A Recession Is Priced Chart 8Go Short EUR/JPY Go Short EUR/JPY Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months.  Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? A Capitulation In The Yen? A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY.  British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro.  Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon.  New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand.  A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk.   The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar.  Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent.  Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon.  Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Swiss Inflation Will Fall Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR.  The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside.  Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg.  Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside SEK Has Upside SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March.  The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year.  Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com   Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary