Hungary

Domestic bond yields in the three major central European markets have recently inched up more than their German counterparts. This is despite economic growth staying quite weak in CE3. What should investors make of it (Chart 1)? Chart 1 CE3 Bond Yields Will Struggle To Fall As Core Inflation Stays Above Target CE3 Bond Yields Will Struggle To Fall As Core Inflation Stays Above Target Our take is that the CE3 yield differential over German bunds will widen in the coming months. That is due both to CE3 currency depreciations and diverging inflation outlooks. CE3 currencies are headed lower as growth in core Europe will continue to struggle.In addition, persistently high wage growth entails that core inflation in CE3 is unlikely to fall any further in the coming months, even if growth disappoints. The end of their disinflation cycle will prevent CE3 bond yields from declining considerably in the next six to nine months. Currencies And Bonds: The Drivers And Outlook CE3 currencies are heading lower vis-à-vis the greenback and the euro. That is because a crucial driver of these currencies—the growth outlook in core Europe—remains tepid (Chart 2). That is unlikely to change much going forward. Uncertainties surrounding Trump’s looming tariffs on Europe will continue to hurt business sentiments and growth in Europe. While the timing of tariffs is unknown, European capitals are preparing for executive actions shortly after Trump’s inauguration on January 20. A weak CE3 currency outlook is also negative for CE3 domestic bonds. Chart 3 shows that a depreciating currency usually coincides with a widening yield differential of CE3 domestic bonds over German Bunds.  Chart 2 Weak Growth In Core EuropeDrives CE3 Currencies Down Weak Growth In Core EuropeDrives CE3 Currencies Down That means CE3 bonds are set to underperform their German counterparts in common currency terms as both drivers of return (‘spreads’ and currency) will work against them. Apart from the currency impact, the CE3 inflation outlook is also bond-negative. Core inflation in the central European economies appears to have bottomed out for now.  Chart 3 CE3 Yield Differential With Bunds Usually Widen When CE3 Currencies Weaken CE3 Yield Differential With Bunds Usually Widen When CE3 Currencies Weaken The reason is persistently high wage growth – mostly due to severe labor shortages. The labor force participation rate is very high in these three countries, leaving little spare capacity in the labor force (Chart 4). Since such demographic challenges cannot be resolved anytime soon, wage growth rates will remain steep in the foreseeable future. Chart 5 shows that wage growth rates dictate CE3 core inflation. The latter, therefore, will likely hover above the central bank’s upper target bands in the foreseeable future. That, in turn, will put a floor under bond yields.  Chart 4 CE3 Labor Shortages Are A Structural Issue CE3 Labor Shortages Are A Structural Issue The bottom line is that CE3 domestic bond spreads versus German bunds will widen both due to CE3 currency weakness and cyclical inflation outlook. That calls for underweighting CE3 domestic bonds vis-à-vis bunds in fixed-income portfolios. CE3 bonds will also underperform their EM counterparts on a similar logic: the cyclical disinflation process is over in CE3 but not in most EM economies. As such, CE3 will likely witness relative bond yield widening vis-à-vis elsewhere in EM.  Chart 5 High Wage Growth Rates Will Keep Core Inflation Above Targets High Wage Growth Rates Will Keep Core Inflation Above Targets A Whiff Of Stagflation?Weak core European growth usually depresses central Europe's highly connected economies. Indeed, the persistent contraction in European manufacturing orders points toward muted CE3 growth ahead (Chart 6).  Chart 6 Weak Core European Growth Hurts CE3 Economies Too Weak Core European Growth Hurts CE3 Economies Too The latter’s domestic headwinds will accentuate that weakness. These headwinds will hurt the Czech and Hungarian economies much more than the Polish economy (details below). However, as mentioned, inflation will remain above the central bank targets everywhere. That suggests a stagflationary environment. Real policy rates in CE3 have not only turned positive, but they are also higher than pre-pandemic levels (Chart 7, top panel). The same can be said about real bond yields.  Chart 7 Monetary Conditions in CE3 Have Tightened Meaningfully Monetary Conditions in CE3 Have Tightened Meaningfully Real bank lending rates have also become restrictive, especially in Poland and Hungary (Chart 7, bottom panel). Put differently, monetary conditions have tightened meaningfully, which is growth-negative.The central banks of Poland and the Czech Republic recently revised down their growth projections for 2025, while revising up their inflation projections. The Polish and Hungarian central banks have also paused their easing cycles. The Czech National Bank lowered its base rate by 25 basis points earlier this month but acknowledged that inflation will remain above the target next year.All this indicates that policymakers are bracing for a stagflationary environment, in which growth remains low but inflation remains above the central bank’s targets.This also means further policy rate cuts will be difficult to come by. The upshot is that real borrowing costs will remain relatively high, further weighing on growth.Data indicates that domestic demand is already weak, particularly in the Czech Republic and Hungary. This can also be seen in retail sales volume levels – which have remained below their 2021-22 peak (Chart 8).  Chart 8 CE3 Retail Sales Volume Levels Are Still Below 2021-22 Peaks CE3 Retail Sales Volume Levels Are Still Below 2021-22 Peaks Fiscal policy has been a headwind, too, particularly in the Czech Republic and Hungary this year. Next year, however, the fiscal thrust will be only marginally negative, as per the IMF. To be sure, Poland is much less exposed to a struggling core Europe than the other two. The country is also set to receive a significant EUR 9.4 billion of EU grants and loans in the coming months (in addition to the EUR 6.3 billion they received in 2024 so far). This will help put a floor under its growth, as those funds will be deployed in various infrastructure projects. Overall, the Polish growth will fare relatively better than the other two. Polish core inflation will also likely perk up more than others. Czech inflation, on the other hand, will be the least pronounced. Geopolitical Risk Premium Spikes In Near TermThe Ukraine war escalated in a way that caught global investors’ attention on November 18 when US President Joe Biden gave Ukraine approval to use long-range missiles against Russia, including targets in the Russian heartland.Biden’s action stemmed from North Korea’s deployment of nearly 10,000 troops to fight Ukrainians near Kursk, Russia, where Ukraine invaded in August. The United Kingdom also gave approval for Ukraine to use long-range missiles. Ukraine promptly staged attacks against Russian supply lines using these missiles, triggering a harsh Russian reaction.Russia retaliated by firing a new hypersonic missile against Ukraine and revising its nuclear doctrine to lower the threshold for the use of nuclear weapons. Previously Russia only said it would use the bomb in the event of an existential threat to the state. Now Russia says it will consider an attack by a non-nuclear state (Ukraine) allied with a nuclear state (e.g. the US or UK) as a joint attack and potentially worthy of a nuclear retaliation. In particular, an extensive Ukrainian barrage of US-made missiles and drones targeting interior Russian cities could cross the new threshold.That is a convincing reason for Ukraine to limit the use of the missiles to targets close to its border, sporadically and only to hit military supply lines. Kiev does not have an interest in crossing Russia’s red lines and provoking a nuclear attack when it cannot be certain of the extent of that attack, the targeting, or that NATO would retaliate. Russia, for its part, would prefer not to use nuclear weapons because of the potential radioactive cloud close to home and the risk that NATO would retaliate by staging a conventional military strike against Russian forces operating in Ukraine. The Kremlin cannot be certain since the NATO states have a strong interest in preventing nuclear blackmail from becoming a new norm.Ultimately, Russia will use nukes if Ukraine goes too far – otherwise, it would not have staked its credibility on this new threat. Note that there is a high probability of near-term escalation of the war, including nuclear brinksmanship, even if the odds of a nuclear detonation remain in the low single digits.First, Ukraine’s fear of abandonment – and need to gain leverage ahead of any ceasefire talks – forces Kiev to escalate the war in the short run.Ukraine expects Trump and the Republicans to reduce military and financial aid since they were elected on the back of inflation and will seek to cut government spending. A loss of American support will signal to Europe that the war is effectively decided, as Ukraine will never join NATO.The Europeans want the war to end sooner rather than later because they fear the danger of a spillover into NATO territory as well as rising domestic political opposition. German and French leaders have already spoken to Vladimir Putin since Trump’s election, as they see the writing on the wall. Thus, Ukraine must take the initiative to prevent the West and Russia from foisting a ceasefire upon it, which is precisely what occurred in 2015 after Russia invaded Crimea.Second, the outgoing Biden administration views the incoming Trump administration as a threat to American democracy and a friend to Russian strategy. Trump wants to bring the war to a rapid ceasefire, but Russia would then succeed at establishing a sphere of influence and exposing a lack of resolve on the part of the Western democracies. Hence, Biden is attempting to speed up financial and military aid to Ukraine so that it can improve its war efforts, increase its leverage, and potentially create enough momentum to prevent Trump from utterly abandoning Ukraine or approving a lopsided ceasefire in Russia’s favor. Thus, the war is escalating as we go to press and will continue for at least the final two months of Biden’s “lame duck” presidency. After that, Trump’s inauguration on January 20 creates a clear diplomatic avenue for the reduction of tensions. Later, after Trump takes office, another risk will emerge for central Europe: the risk that Russia will stage a provocation against a NATO country to test whether Trump will “defend every inch” of the alliance’s territory, as Biden pledged to do. If Trump hesitates, Russia will undermine Eastern European trust in NATO, increasing the central European geopolitical risk premium. If not, Russia knows its limits for a while. Bottom Line: There is a major increase in Russia-NATO tensions around the endgame in Ukraine, which should inject a risk premium into Polish, Hungarian, and Czech currency and assets at least for the next few months around the US power transition and possibly for a while longer. Investment ConclusionsCurrency: The Polish zloty has been the strongest of the three currencies over the past year as the markets celebrated Poland’s political return to the European manifold after the elections late last year. Now that event has been largely priced in, and the geopolitical risk is rising again. Investors should expect a relapse in Poland’s currency and share prices. A weak core European growth outlook means all CE3 currencies have a further downside compared to the greenback. Currency investors should stick with our recommendation of shorting an equal-weighted basket of CE3 currencies versus the greenback (Chart 2, above).Fixed Income: Considering the inflation outlook and currency prospects, we recommend that EM domestic bond portfolios downgrade the Czech Republic from overweight to neutral and Poland and Hungary from neutral to underweight.Investors should also take the same stance relative to German bunds: neutral the Czech Republic and underweight the other two (Chart 9).Notably, on October 21, 2024, we closed our long position in Czech domestic bonds. For USD-based investors, this recommendation has returned a 12.7% gain since its inception on December 08, 2022.We also booked profits on our trade “Pay Polish 2-year swap rates / Receive Czech 2-year swap rates,” which yielded 120 bps gains since its initiation on November 22, 2023. Equity: Given the weak growth outlook, the CE3 stock prospects remain lackluster. Tight monetary stances in all three countries and a negative fiscal thrust in the Czech Republic and Hungary will add to their headwinds. EM equity portfolios should downgrade both Polish and Czech stocks from overweight and neutral, respectively, to underweight. Hungary should also remain underweight (Chart 10).  Chart 9 Downgrade CE3 Domestic Bonds Relative To Their EM And German Counterparts Downgrade CE3 Domestic Bonds Relative To Their EM And German Counterparts Chart 10 Weak Core European Outlook Will Weigh On CE3 Stock Performance Weak Core European Outlook Will Weigh On CE3 Stock Performance The rise in geopolitical risk in the region will likely exacerbate pressures on CE3 assets in the short term.Rajeeb PramanikSenior EM Strategistrajeeb.pramanik@bcaresearch.comMatt Gertken Chief Geopolitical Strategist mattg@bcaresearch.comFollow me onLinkedIn & X 

The disinflation process is over in Poland and Hungary. Only the Czech Republic will see its core inflation meet its central bank target this year. The reason is much tighter labor market dynamics in the first two. Investors should continue to short a basket of CE3 currencies vis-à-vis the US dollar.

Real wages are set to rise in CE3 economies with implications for their asset markets and currencies. Of the three, Polish assets and the zloty are the most vulnerable.

The growth and inflation profiles of the three central European countries are set to diverge. The outlook for Polish and Hungarian Bonds are not attractive anymore. Book profits on them. Instead, initiate a new trade: pay Polish / receive Czech 10-year swap rates.

It’s time to go overweight Hungarian domestic bonds in an EM and European core bond portfolios. Currency investors should book profits on our long CZK / short HUF trade, which has generated 29.4% gains since its inception in June last year.

Executive Summary Poland: Wages Are Surging Poland: Wages Are Surging Poland: Wages Are Surging Hungary is exhibiting classic signs of an overheating economy –as rising inflation coincides with very strong domestic demand. Yet, authorities are still pursuing very stimulative monetary and fiscal policies. The upcoming appointments of new Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Core inflation in Poland will continue to rise due to the unfolding wage-price spiral. The reluctance of policymakers to tighten monetary and fiscal policies substantially in such an environment heralds a weaker currency and higher local bond yields. Continue to underweight Central European equities and local currency bonds relative to their respective EM benchmark. Underweight Central European local currency bonds within European core bond portfolio. Recommendation INITIATION DATE RETURN Receive Czech And Pay Polish 10-Years Swap Rates 2022-03-08 100 BPS Long CZK/Short HUF 2021-06-03 12.4% Short PLN/Long USD 2022-03-02 3.1% Bottom Line: The Hungarian and Polish economies are overheating, yet their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will cultivate a more dovish stance than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts.   Hungary: Classic Overheating Chart 1Hungary Is Overheating Hungary Is Overheating Hungary Is Overheating The Hungarian economy is exhibiting signs of classic overheating as rising inflation coincides with very strong domestic demand (Chart 1). Yet, authorities are not tightening monetary and fiscal policies meaningfully. The central bank is well behind the inflation curve. Accordingly, the currency will continue to depreciate and local bond yields will rise. The only way to reverse these dynamics is for authorities to tighten monetary or fiscal policies dramatically, which will likely cause a recession. Looking forward, authorities will continue to pursue their pro-growth agenda despite the unfolding wage-price spiral. Inflation is broad-based and will accelerate further. High inflation is not limited to goods. Core, trimmed-mean and service inflation are also very high, in some cases in double digits (Chart 2). Chart 2Hungary: Inflation Is Broad-Based Hungary: Inflation Is Broad-Based Hungary: Inflation Is Broad-Based Chart 3Hungary: Wage Growth Is In Double Digits Hungary: Wage Growth Is In Double Digits Hungary: Wage Growth Is In Double Digits Hungary’s labor market is tight, and wages are surging (Chart 3). Notably, wage growth is in double digits and is well above core inflation. Wage growth will remain robust as the government is set to boost public wages and the private sector is struggling to fill vacant positions. Employment is at an all-time high, and the number of unemployed people is approaching pre-pandemic lows (Chart 4). Strong employment and solid real wage growth will support consumer spending for now.   Despite a major slowdown in the euro area, Hungarian exports will suffer less than those of other EU members. Almost 50% of Hungary’s manufacturing output comes from automotive, food and beverages, as well as industrial electrical equipment sectors. Demand for these sectors remains robust despite a potential drop in demand for consumer goods in the EU.   Despite the central bank raising rates by a cumulative 530 bps since June 2021, real policy rates and real commercial bank lending rates (deflated by core CPI) are at all-time lows, and money and private credit are booming (Chart 5). In brief, the central bank remains behind the inflation curve. The National Bank of Hungary (NBH) has also been the most aggressive central bank in the region in monetization of public debt and corporate debt. There is little evidence to suggest that it is planning to tighten liquidity as a means of reining in inflation. Chart 4Hungary: Labor Market Is Currently Very Tight Hungary: Labor Market Is Currently Very Tight Hungary: Labor Market Is Currently Very Tight Chart 5Hungary: Money And Credit Are Booming Hungary: Money And Credit Are Booming Hungary: Money And Credit Are Booming Chart 6Hungary: Twin Deficit Hungary: Twin Deficit Hungary: Twin Deficit Fiscal policy will remain loose and unorthodox measures will likely persist. Government primary spending has reached 46% of GDP and is unlikely to retrench much. In particular, in response to the EU’s recent €7.2 billion (4.6% of GDP) cut in funding to Hungary, prime minister Orbán has announced spending cuts and tax hikes to prop up government revenues (Chart 6, top panel). The government has imposed “windfall” taxes1 on some firms or industries where profits are excessive from the government’s perspective. The majority of spending cuts (€3 billion or 2% of GDP) will be in public investments. Meanwhile, authorities continue subsidizing household utility bills and raising public wages and pensions. This will keep consumption strong.   A very wide current account and trade deficits are also signs that the economy is overheating (Chart 6, bottom panel). Bottom Line: Super-loose monetary and fiscal policies amid an overheating economy warrant further currency depreciation and higher bond yields.  The Czech Republic: A Policy Shift Coming The recent appointments of Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Notably, Aleš Michl, a current board member of the monetary policy committee, has been a strong opponent of the CNB’s hawkish stance alongside current board member Oldřich Dědek. Both men have been the only two of the seven-member  committee to vote against rate hikes in the past eight meetings. In addition, President Zeman recently appointed three new members to the monetary policy committee to replace hawkish members that have reached the end of their terms. These new appointments are likely to be aligned with the forthcoming CNB governor’s dovish approach to monetary policy. Chart 7Czech Output Gap And Core Inflation Czech Output Gap And Core Inflation Czech Output Gap And Core Inflation Altogether, these appointments will result in a major shift in the CNB’s monetary policy board, whereby at least four out of the seven board members will likely vote against further rate hikes after July. Therefore, the CNB policy will undergo a dovish pivot. This will occur at a time when genuine inflation is still high and inflationary pressures are intense: The very large positive output gap heralds persistent inflationary pressures (Chart 7, top panel). Indeed, core and trimmed-mean CPIs are surging, which suggest that inflation is broad-based (Chart 7, bottom panel). Job vacancies exceeding the number of unemployed people entails a very tight labor market (Chart 8). The upshot is rising wages (Chart 9).   Domestic consumption remains robust due to considerable household income gains. Chart 8The Czech Republic: Labor Shortages Are Pervasive The Czech Republic: Labor Shortages Are Pervasive The Czech Republic: Labor Shortages Are Pervasive Chart 9Wage Growth Is Lower In Czech Than In Hungary And Poland Wage Growth Is Lower In Czech Than In Hungary And Poland Wage Growth Is Lower In Czech Than In Hungary And Poland Chart 10Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland On the one hand, a dovish monetary policy shift is negative for the Czech koruna. On the other hand, the country’s fiscal thrust will still be negative this and next year (Chart 10). This is in contrast to Hungary and Poland. Besides, the central bank considers a weak currency to be a risk to its “fulfilment of price stability” and regards the “easing of the monetary conditions” as “inappropriate”. Last month, the CNB board convened in an emergency meeting to announce the selling of foreign exchange reserves to stem volatility in the currency. The Czech Republic has a lot of foreign exchange reserves that could be utilized to stem any large moves in the koruna. Even newly appointed governor Aleš Michl considers a strong koruna to be an important part of his mandate. His recent comments to local media suggest that the CNBs’ intention is to defend the currency against any medium to long-term weakness: “I want a strong koruna based on long-term cash flows to the country and investor interest in the Czechia. The koruna has not strengthened in trend since 2008. Everyone is only evaluating short-term fluctuations, but they do not perceive this significant change. The koruna will only be strong if we have long-term balanced public finances.” Overall, the selling of foreign exchange reserves to defend the currency will tighten monetary conditions and prevent short-term interest rates from falling. Whenever a central bank sells foreign currency, it is forced to purchase local currency which lowers commercial banks’ excess reserves at the central bank. The latter could reduce money origination by commercial banks. While long-term bond yields could rise as the central bank falls behind the inflation curve, the currency will likely be range bound versus the euro for some time. Bottom Line: Even though the central bank is shifting into a dovish mode, it will maintain the policy of a strong currency. Plus, the fiscal policy will be tightening, which is not the case in Hungary and Poland. We reiterate our long CZK / short HUF trade. Poland: Misguided Macro Policy Chart 11Poland: Wages Are Surging Poland: Wages Are Surging Poland: Wages Are Surging Inflation in Poland will continue to rise due to the unfolding wage-price spiral (Chart 11). Besides, the central bank is still behind the inflation curve, and fiscal policy has not tightened substantially. The reluctance of policymakers to tighten monetary and fiscal policies amid the wage-price spiral warrants a weaker currency. Also, a top in domestic bond yields might not be imminent. A buying opportunity in Polish local currency bonds will emerge only when authorities take measures to bring down inflation and when geopolitical tensions between Russia and the west abide. The central bank and government continue to blame inflation on the war in Ukraine, i.e., on supply-side factors rather than excessive domestic demand. Chart 12Poland: Consumer Spending Has Overshot Poland: Consumer Spending Has Overshot Poland: Consumer Spending Has Overshot Contrary to policymaker rhetoric, Poland is experiencing an inflationary boom, whereby rising inflation is not only the result of supply-side bottlenecks but is also due to excessive demand. Chart 12 illustrates that retail sales have overshot above a reasonable uptrend trajectory. Critically, the labor market is very tight. As a result, wage growth is skyrocketing both in nominal and real terms. With productivity growth well below wage growth, unit labor costs are accelerating. This will squeeze company profit margins and lead these to hike selling prices to protect profit margins. With such robust income growth, consumers might accept higher prices and the wage-price spiral will likely be sustained. Meantime, fiscal policy will remain accommodative at least throughout early 2023, until the scheduled parliamentary elections take place. The government has provided subsidies on energy and has cut the VAT rate. These programs effectively amount to stimulus for households. Chart 13Poland: Interest Rates Are Very Low/Negative Poland: Interest Rates Are Very Low/Negative Poland: Interest Rates Are Very Low/Negative In addition, the central bank will not likely hike rates aggressively. Recent comments by central bank governor Adam Glapinski appear to suggest that the National Bank of Poland (NBP) is likely to pause or slow its rate hikes. Even though the central bank has hiked its policy rate by 590 bps in the past 12 months, real policy and prime lending and mortgage rates as well as government bond yields remain very negative (Chart 13). This signifies that the monetary tightening has been insufficient. Lastly, in the current geopolitical climate, Poland is the most vulnerable among Central European nations to any escalation between Russia and the west. This is due to its extensive border with Ukraine, and due to it being the transit route for arms into Ukraine from the west. Poland has adopted a hard stance on Russia. This makes Poland an easy target for Russian rhetoric. While chances of direct conflict are slim, any further escalation by Russia will make Polish financial markets vulnerable to selloff. Bottom Line: For now, investors should continue to underweight Polish domestic bonds within both EM local currency bonds and core European bond portfolios. Also, we continue to recommend shorting PLN versus the USD. Investment Recommendations The Hungarian and Polish economies are overheating, and their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will be more dovish than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. Hence, the inflation outlook is more benign for the Czech economy than it is in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts. Chart 14Our Trade: Long CZK / Short HUF Our Trade: Long CZK / Short HUF Our Trade: Long CZK / Short HUF In light of this, we recommend the following to investors: Underweight Central European local currency bonds within European core bond portfolio. Keep the long CZK / short HUF trade (Chart 14); Hold onto the short PLN / long USD trade. Maintain the relative rates trade of receiving Czech and paying Polish ten-year rates. This spread has widened by 100 bps since our recommendation on March 8, 2022. Maintain underweight in local bonds and equities for Central Europe relative to their respective EM benchmarks.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     A windfall tax is extra tax on profits of a particular company or industry that is deemed to have earned excessive profits.

Executive Summary Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent With German imports of Russian oil close to 10% of its total requirements – following an impressive decline from 35% pre-invasion – we expect the EU to declare an embargo on Russian oil imports this week or next. Smaller states – e.g., Hungary and Slovokia – will be granted embargo waivers; their import volumes will not affect the EU effort. Russia will be forced to shut in ~ 1.6mm b/d of production, rising to 2mm b/d next year (vs. pre-invasion levels). Demand will fall as Brent prices surpass $120/bbl by 2H22, in our revised base case. Prices above $140/bbl are likely if Russia immediately halts EU oil exports. Our revised forecast calls for Brent to average $113/bbl this year, and $122/bbl next year. WTI will trade $3/bbl lower. Per earlier threats, Russia will cut EU natgas exports following the EU embargo. Benchmark euro natgas prices will go back above €225/MWh, and trigger an EU recession. Bottom Line: An EU embargo on Russian oil imports is close. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher likely, depending on how quickly Russia reacts to the EU oil embargo. Eurozone natgas will trade above €225/MWh again. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and 4Q22 TTF futures at tonight's close. Feature Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise The stage is set for the EU to announce an embargo on Russian oil imports this week or next. Odds of an EU embargo being declared sooner rather than later increased, in our view, in the wake of Germany's success in cutting Russian oil imports by more than half in a very short period – from ~ 35% prior to Russia's invasion of Ukraine on 24 February to ~ 12% earlier this month (Chart 1). Further reductions in Russian oil imports we expect from Germany will make it easier for the EU's largest economy to walk away from Russian crude and product imports sooner rather than later.1 Other EU member states already stand with Germany on the issue of an embargo on Russian imports. Those that do not – Hungary and Slovakia, e.g. – do not import Russian oil on a scale that can meaningfully derail EU solidarity on the embargo, which means waivers for these states can be expected to keep the embargo on track. In addition, four of the Five-Eyes states – the US, UK, Australia and Canada – already have imposed embargoes on Russian oil imports. Chart 1EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) Russian Shut-ins Will Tighten Supply The immediate fallout of the EU embargo will be to accelerate the rate at which Russia is forced to shut in production, as increasing volumes of its oil remain stranded on the water looking for a home. We reckon 1mm b/d or so of Russian crude oil output already has been cut. This will continue to increase. Russia will be forced to shut in ~ 1.6mm b/d of crude output this year, rising to 2mm b/d next year (averages vs. pre-invasion levels), in our modelling. This takes Russian oil production down to 8.4mm b/d this year, on average, and 8.0mm b/d next year.2 As more and more Russian crude is shut in, the pipelines carrying Urals and Eastern Siberia-Pacific Ocean (ESPO) crude from the Siberian oil fields to ports will fill, along with inventory in the ports where ships are loaded for export. When storage and pipelines fill, the only alternative Russian producers will have will be to shut in crude and condensate production. While some states obviously will benefit from the increasing availability of Russian crude on offer at 30% discounts or more – e.g., India and China – there is a limit as to how much surplus Russian output they can take in. China, in particular, will not want to jeopardize long-term contracts with key suppliers – e.g., the Kingdom of Saudi Arabia (KSA) – nor will India, which will limit the total volumes both are willing to take from Russia longer term. Security of supply becomes an increasingly important consideration as Russia's oil output continues a long-term decline going forward: Costs were rising prior to Russia's invasion of Ukraine from 2008 to 2019. Falling drilling efficiency and production, were accompanied by rising water cuts – i.e., the amount of water being produced drilling for oil – in Russia's largest fields, which rose to as high as 86%. Shutting production from these older fields will force hard choices as to whether these fields are ever revived.3 Demand Will Be Stressed Shortly after Russia invaded Ukraine, the country's Energy Ministry Alexander Novak warned the EU it would cut off natural gas pipeline supplies being sent to the continent, in retaliation for embargoing oil imports.4 Oil exports of close to 5mm b/d accounted for just under half of Russia's revenue from energy exports last year, with OECD Europe representing half of that amount.5 For Russia, oil exports are far more important than gas exports, which will incline it to immediately cut pipeline flows to Europe as soon as an oil embargo is announced. For the EU, natgas exports from Russia are critical to the economies of its member states (Chart 2). The EU imported ~ 155 bcm of natgas from Russia in 2021, or just over 40% of its total natgas consumption. Germany's share amounted to 45 bcm, or 45% of domestic gas use . If, as we expect, the EU is close to announcing its oil embargo on Russia, an immediate retaliation from Moscow in the form of a cutoff of pipeline exports to the EU most likely will follow. This will throw the EU into a recession, as natgas prices surge. Chart 2Losing Russia's Natgas Will Be Painful For EU Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Revised Forecast Reflects Falling Russian Output We are revising our Brent forecast and crude oil balances in line with our expectation Russian oil output will decline meaningfully. As noted above, we now expect Russian crude oil output to fall to 8.4mm b/d this year and 8.0mm b/d in 2023. This pushes non-core OPEC 2.0 production – which now includes Russia – lower, as a result (Chart 3). We moved Russia out of the core OPEC 2.0 producer group, given the production declines we expect this year and next, and into the "Other Guys" group. Our base case demand reflects a shift in OECD vs. non-OECD consumption estimates, with the OECD gaining incrementally, while EM demand (via non-OECD consumption) falls incrementally (Chart 4). Chart 3Falling Russia Output Pushes Non-Core OPEC 2.0 Output Lower Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 4DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower The lower EM demand growth reflects weaker China oil consumption resulting from the country's zero-COVID policy. In addition, because we expect Russia to act quickly on cutting off EU natgas exports, benchmark TTF natgas prices will move back above €225/MWh. Higher oil and natgas prices in the EU will lead to recession later this year. How quickly this shows up depends on how quickly Russia reacts to an EU oil embargo. In addition, a strong USD – bid higher by global economic uncertainty and safe-haven demand – will pushing the local-currency costs of refined products like gasoline, diesel and jet fuel higher, also will contribute to lower EM demand (Chart 5). Chart 5USD Remains Well Bid Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge In our base case, we expect a tighter market on balance (Chart 6). Oil inventories remain under pressure, owing to falling as Russian output and declines in production outside core OPEC 2.0 and the US (Chart 7). We cannot rule out additional SPR releases from the US or IEA to offset tightening global inventories. Chart 6Global Balances Tighten Global Balances Tighten Global Balances Tighten Chart 7Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Our forecast for Brent this year has been lifted on the back of a much stronger expectation of an EU oil embargo against Russia. This will result in 2mm b/d of Russian production being shut in by next year, which will not be fully replaced (Table 1). We are lifting our Brent forecast to $110/bbl for 2022, and $115/bbl for next year as a result (Chart 8). Chart 8Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Investment Implications An EU embargo on Russian oil imports is close at hand, in our view. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher possible, depending on Russia's reaction to the EU oil embargo. We expect Brent prices to average $113/bbl this year, and $122/bbl in 2023. WTI will trade $3/bbl lower on average. Eurozone natgas will trade above €225/MWh again and stay at elevated levels, likely moving higher following a Russian cutoff of natgas supplies to the continent. This will throw the EU into recession. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and TTF natgas futures at tonight's close. A word of caution is in order: We are assuming Russia will follow through on its threat to shut off natgas exports to the EU in the event of an embargo against importing its oil is declared. This, we believe, is Russia's red line. If the EU fails to declare an embargo, or if Russia fails to follow through on its threat to cut off gas supplies in the wake of an EU oil embargo of its exports we will have to re-assess our outlook.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas inventories are building at a rapid rate, as competition from Asia – typically led by Chinese demand – remains weaker than in previous seasons. EU natgas storage stood at ~446 MWh as of May 16, 2022, the latest available reports indicate (Chart 9). The EU has weathered two extremely difficult winters in 2020-21 and 2021-22. Natgas storage levels were drawn hard to meet space heating demand, which, owing to a winter energy crisis in China at the time, forced European buyers into a competition for liquified natural gas (LNG) during the former period. Following unexpected spring-summer demand in 2021 when cold weather lingered in Europe and wind power generation fell sharply, storage owners again were hard pressed to secure LNG to rebuild storage levels going into this past winter, which caused European TTF natgas prices to soar, as demand surged (Chart 10). With the threat of a cutoff of Russian natgas hanging over the EU, there is a singular focus right now on getting storage as full as possible ahead of next winter. The EU aims to replace two-thirds of Russian gas imports before yearend. Precious Metals: Bullish The Fed has adopted a more hawkish rhetoric, as it acts more aggressively to reduce US inflation. Interest rates have increased from near-zero levels in March to 0.75%, and BCA’s US Bond strategy service expects two more 50 bps rate hikes in June and July. Post July, rate hikes will depend on the Fed’s assessment of inflation, inflation expectations and financial conditions. The Fed faces the risk of either remaining behind the inflation curve or sparking a recession in case it’s either not hawkish enough, or too hawkish. Base Metals: Bullish High power prices in Europe will continue to plague refined base metals production in the continent and keep refined metal prices buoyed. LME Europe aluminum stocks are close to 17-year lows. In China – whose metal smelters were also hit by high power prices in 2021 – aluminum smelting has revived, with the country reportedly producing a record amount of primary aluminum in April. Lockdowns, however, have reduced economic activity, demand for the metal and its domestic price. China has taken advantage of this arbitrage opportunity, sending most of its primary aluminum exports to Europe. This aluminum price spread between the two states has contributed to China’s steady rise in primary aluminum exports this year, after having exported nearly none in 2020 and 2021. Chart 9 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 10Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down     Footnotes 1     German officials have stated the country will wind down all oil imports from Russia by year end, even if the rest of the EU does not join it in an embargo.  We highly doubt Germany will act alone, given the support an embargo already has received from EU member states.  Please see Germany to Stop Russian Oil Imports Regardless of EU Sanctions, published by bloomberg.com on May 15, 2022. 2     Our expectation for shut-in volumes is lower than the IEA's, which sees Russia being forced to shut in 3mm b/d of production by 2H22.  We continue to monitor this closely via satellite and reporting services and will adjust our estimates as needed.  Obviously, if the IEA is correct oil markets will tighten even more than we expect. 3    Please see "The Future of Russian Oil Production in the Short, Medium, and Long Term," published by the Oxford Institute for Energy Studies in September 2019.  The OIES study notes production in Russia's highest-producing area – the Khanty-Mansi Autonomous (KMA) district – actually fell 15% between 2008-19, even as drilling activity surged 66%.  While output in 2018 rose due to intensified oil recovery (IOR), the OIES noted that the water cut rose sharply in 2018 as well in the KMA district. 4    Please see Russia warns of $300 oil, threatens to cut off European gas if West bans energy imports, published by cnbc.com on March 8, 2022.  The article notes Novak threatened to close the Nord Stream 1 pipeline delivering gas to Germany in retaliation for an EU oil embargo.  Almost three-quarters of Russia's natgas exports were sent to Europe prior to its invasion of Ukraine.  Natgas export revenues accounted for $62 billion of the $242 billion funding Russia's budget last year, while crude oil revenues made up $180 billion (just under 75%). 5    Please see Die Cast By EU: Inflation, Recession Risks Rise, which we published on May 5, 2022.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022