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Executive Summary Central banks are aggressively tightening policy around the world. Their ability to rein in inflation without causing a recession depends upon the level of the real neutral rates. Australia, Canada, New Zealand, and Sweden have elevated r-stars, but the picture changes drastically when their large debt loads are factored in. While real policy rates remain below r-star across DM economies for now, a more rapid decline in supply-driven inflation would correct this situation. Consequently, a global recession does not constitute our base case for the next six months, although it is a growing threat. The ECB is front-loading interest rate increases while it can, but the destination of travel is not changing significantly. Global R-Star Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The global r-star varies greatly around the world and debt sustainability concerns weigh on the real neutral rates of Australia, Canada, New Zealand, and Sweden. The US economy remains best capable of handling higher interest rates.   Chart 1Rising Global Inflation Rising Global Inflation Rising Global Inflation Inflation around G10 economies has been very strong and much more durable than originally hoped. As a result, inflation now averages 7.1% on a headline CPI basis and 4.6% based on core CPI across among G10 economies (Chart 1). Central banks are tightening policy aggressively to prevent this elevated inflation from becoming entrenched. Essentially, they are aiming to avert the emergence of the kind of inflationary mentality that prevailed in the 1970s, which caused stubborn inflation during that decade. This exercise is fraught with difficulty. The objective is to achieve a policy setting that is slightly above the neutral rate of interest, but not too much so. On the one hand, keeping policy too accommodative will increase the chances that an inflationary mentality will emerge; on the other hand, if policy is tightened too much, a recession will become unavoidable and deflationary risks will escalate. A sense of where the neutral rate for major economies lies is therefore necessary to draw that line in the sand. To do so, we estimate the real neutral rate of interest for major DM economies using the methodology we introduced seven weeks ago, when we evaluated the neutral rates for the major Eurozone economies. This exercise shows that, at the current level of interest rates and inflation, policy among major economies remains accommodative. However, if inflation decelerates sharply in the coming months in response to declining global supply constraints and lower commodity prices, the recent increase in policy rates will have already gone a long way to normalizing monetary policy around the world. A Simple Approach The methodology we use is based on the approach developed by Holston, Laubach, and Williams (HLW)  to estimate the neutral real interest rate – or “r-star.” Specifically, we run regressions between the real interest rates in the US, Japan, the UK, New Zealand, Canada, Australia, Sweden, and Switzerland versus trend GDP growth and current account balances, which approximate the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average of core CPI.1  Table 1Unadjusted R-Stars Neutral Rates Around The World Neutral Rates Around The World The results are shown in Table 1. New Zealand, Australia, and Canada have the highest real-neutral rate of the major economies. They have had stronger growth over the past 20 years because of their rapid population growth caused by high immigration rates. Moreover, their commodity-based economies and their booming construction sectors pushed up investment rates, which requires high interest rates to attract sufficient savings to finance. Sweden and the US follow. These two economies have lower population growth rates than the commodity producers; nonetheless, they outperform Japan and the other European nations in the survey on that dimension. Moreover, they fare comparatively well in terms of productivity growth, which implies that their trend growth – a key driver of the neutral rate – is also higher than that of the UK, Japan, Switzerland, or the Euro Area. The US’s r-star shows up as being slightly below what would be expected based on its potential GDP growth. This surprising outcome most likely reflects the role of the dollar in global FX reserves and its standing at the core of the global financial system. These two characteristics of the greenback create an important demand for dollar-denominated assets that is dissociated from US domestic economic fundamentals. This additional demand biases downward the US real neutral rate and suggests that weak trend growth abroad and global excess savings remain important forces for US financial markets. Chart 2Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan's Dissociated Real Rates Japan displays a surprisingly elevated real neutral rate of 0.1%. This result reflects the limitation of the approach. Japanese interest rates have been at zero since the late 1990s and real rates have been negatively correlated with inflation because of this nominal rigidity (Chart 2). However, while Japanese inflation has averaged a paltry 0.2% since 1997, it has nonetheless fluctuated with commodity prices and global economic activity. As a result, real rates have been essentially dissociated from Japanese domestic drivers. Hence, an empirical approach based on the evolution of domestic economic variables yields poor results for Japan. Instead, the lack of inflation when public debt has increased by 200% of GDP over the past 32 years and Japan’s large net international investment position imply that its r-star is inferior to that of the other countries in the sample, and thus should lie below -1%. For the Eurozone, we use the average result of our July study, which estimated the neutral rates of Germany, France, Italy, and Spain independently. Germany flatters this estimate since its real neutral rate stands near 0%. An average, excluding Germany, would be closer to -0.5%, or well below the US r-star. Meanwhile, the Swiss r-star is depressed by both a low population growth and the Swiss exceptional savings generation, as highlighted by its current account surplus that has averaged 8% of GDP over the past 20 years. Finally, the UK’s r-star stands at the bottom of the pack. The UK’s productivity growth has been very poor over the past ten years, averaging 0.7% per annum. This points to a weak potential GDP for that economy. Moreover, the hurdles to UK growth have only increased in recent years with the implementation of Brexit, which is hurting the availability of labor in the country, while putting the UK at an even greater disadvantage in European markets, its largest export destination. What About Debt? This approach to estimating r-star ignores a key dimension: debt sustainability. If we factor in this crucial variable, the level of interest rates causing economic activity to decelerate changes drastically for many countries. Chart 3Massive Real Estates Bubbles Massive Real Estates Bubbles Massive Real Estates Bubbles Since 2000, real estate prices have surged by 280%, 220%, 170%, and 200% in New Zealand, Canada, Australia, and Sweden, respectively. These gains dwarf the house price appreciation observed in the US, the UK, Japan, or Germany (Chart 3, top panel). This outperformance of house prices is particularly problematic because it does not reflect more rapid underlying cash-flow growth from the assets. Instead, the main driver of the stronger house prices in New Zealand, Canada, Australia, and Sweden has been the explosion of their price-to-rent and price-to-income ratios (Chart 3, bottom two panels). Rising real estate prices boosted economic activity relative to the underlying trend GDP of these countries. As a result, the long-term growth numbers of these four nations potentially overstate their underlying rate of growth. Even more importantly, real estate prices and activity are extremely sensitive to interest rates. Therefore, the risk of bursting bubbles in New Zealand, Canada, Australia, and Sweden limits how high interest rates may rise there without causing growth to plunge and deflationary spirals to emerge. Chart 4Rapidly Rising Debt Loads Rapidly Rising Debt Loads Rapidly Rising Debt Loads The accumulation of debt in these four countries accentuates the threats to growth created by real estate activity. The private-sector debt of New Zealand, Canada, Australia, and Sweden has risen much more quickly than has been the case in Germany and the US (Chart 4). Ultimately, these debt burdens create major headwinds against higher interest rates and suggest that the effective r-star of these nations lies well below the estimates constructed using only trend growth and the savings/investment balance. Table 2Drastic Changes Once Debt Is Accounted For Neutral Rates Around The World Neutral Rates Around The World To account for the private-sector leverage, we estimated new debt-adjusted r-stars. The impact of high debt loads on r-star estimates is evident in Table 2. The average real neutral rate of New Zealand, Australia, and Canada drops from 1.9% to -1.9%. In fact, Australia and Canada would sport the lowest r-star estimates of the nations under study. Sweden’s neutral rate also experienced a big decline from 0.6% to 0.2%. The US r-star estimate is also lowered by the addition of debt metrics in its equation, declining from 0.2% to -0.4%. The Eurozone average r-star experiences a significant decrease as well, driven mostly by Spain and France. The Swiss economy also sports a large private debt load, and its r-star is therefore curtailed from -0.75% to -1.3%. Finally, Japan’s r-star estimate barely changes, which confirms that the approach does not work well for that country. The greatest drawback of the method is that it is backward-looking. The main force that has brought down the global r-star over the past 20 years is the collapse in trend growth among most advanced economies (Chart 5). Consequently, neutral rates could improve from their current low levels if trend growth were to pick up in the coming years. On the positive side, the current age of the capital stock in both Europe and the US is extremely advanced (Chart 6), which suggests that a capex upturn is likely. Such an upturn would boost productivity and lift the r-star among most major economies. On the negative side, the growth of human capital is deteriorating as educational attainment stalls among most DM nations. The decline in the growth rate of human capital is a large threat to productivity over the coming decades. These problems are magnified in the Eurozone, as its high degree of economic fragmentation, lack of common fiscal policy, and higher regulatory burden create further handicaps to trend growth. Chart 5R-star And Global Growth R-star and Global Growth R-star and Global Growth Chart 6A Capex Revival? A Capex Revival? A Capex Revival? Bottom Line: Estimating the real neutral rates for the global economy often relies on trend growth and the savings/investment balance. However, such an approach often misses the vulnerability to higher interest rates created by high private-sector indebtedness. If this constraint is considered, the high r-star recorded in countries like New Zealand, Australia, or Canada is reduced dramatically. The US r-star also declines but significantly less so. As we already showed seven weeks ago, the same phenomenon is also visible in the Eurozone, albeit driven by France and Spain, not Germany or Italy. Investment Implications There are three main conclusions from the analysis above. First, the risk of a financial accident in commodity-producing economies is growing increasingly large. On the one hand, economies like New Zealand, Australia, and Canada are buoyed by the recent surge in commodity prices, with agricultural prices up 90% since their 2020 lows, metal prices up 68%, and energy prices up 340% since April 2020. On the other hand, the inflationary pressures created by robust commodity sectors invite the RBNZ, the RBA, and the BoC to lift interest rates quickly, which is hurting massively indebted private sectors. Already, in response to the 275bps and 300bps of hikes implemented by the RBNZ and the BoC, house prices in New Zealand have begun to buckle, down 12% and since their more recent peaks, and they are expected to plunge by as much as 25% in Canada by the end of next year. Chart 7NZD And CAD At A Disadvantage Neutral Rates Around The World Neutral Rates Around The World This suggests that non-commodity equities in Canada, Australia, and New Zealand, especially financials, could experience significant periods of underperformance, both against their domestic equity benchmark and global market averages. Additionally, while the NZD, AUD, and CAD all benefit from improving terms of trades, the potential for domestic weakness is such that these currencies are likely to lag their historical sensitivity to commodity price fluctuations. In fact, according to BCA’s foreign exchange strategist, the New Zealand and Canadian dollars are among the most expensive currencies in the G10 (Chart 7), and thus, it is likely to underperform other pro-cyclical currencies once the USD bull market reverses. Second, the neutral rate in the US has risen by 200bps relative to the rest of the world over the past seven years. The US economy has undergone a long deleveraging period in the wake of the GFC, which means that its private-debt-to-GDP ratio has declined relative to other advanced economies. Consequently, the vulnerability of the US economy to higher interest rates has decreased, even if relative US trend growth has not improved meaningfully. The market implications of this pickup in the neutral rate are manifold. To begin with, it allows US rates to rise further relative to other DM economies. BCA’s Global Fixed Income Strategy team continues to underweight US Treasurys in global fixed-income portfolios, especially relative to German Bunds (Chart 8). As a corollary, it also means that US financials are likely to continue to outperform their foreign peers, especially Canadian and Australian ones which will bear the brunt of the negative consequences of their debt bubbles. The increase in the US r-star relative to the rest of the world has been a key contributor to the dollar rally. It helps explain why the recent dollar strength has not hurt relative profit growth (Chart 9). However, the dollar is trading at a 32% premium to its purchasing power parity, or the same overvaluation as in 1985 and 2001. Thus, with the worsening US balance of payment picture, the US dollar is vulnerable to an eventual improvement in global growth next year. Chart 8US Rate Differentials Have Upside Neutral Rates Around The World Neutral Rates Around The World Chart 9The US Fares Better The US Fares Better The US Fares Better Chart 10Easy Or Not? Easy Or Not? Easy Or Not? Finally, despite the recent increase in rates, the high level of inflation recorded around the world implies that real policy rates are still well below r-star for major global economies, whether one uses actual inflation or the smooth formulation recommended by the HLW paper (Chart 10). This suggests that a recession is unlikely, especially in the US. The recession threat is higher in Europe but has little to do with policy. It is mostly a consequence of the massive terms of trade shock caused by the sudden jump in European energy prices in the wake of the Ukrainian war. However, because policy remains accommodative even in Europe, it follows that the Eurozone economy will rebound quickly once the worst of the energy shock is over next spring. Some humility is required. It is hard to gauge how much of the inflation surge over the past 18 months reflects supply factors. If inflation suddenly becomes much weaker because the easing in supply constraints has a greater-than-anticipated impact on inflation, real interest rates would jump rapidly around the world. In this scenario, policy rates could rise quickly and overtake r-star. This would mean that the disinflation impulse could rapidly morph into an outright deflationary environment, which implies that the odds of a deflationary bust like the one experienced in 1921 is greater than the market currently prices in.  Bottom Line: The debt-fueled real estate bubbles in the dollar-bloc economies suggests that they are at a greater risk of a financial accident than the US or the Eurozone. As a result, their financial sector looks vulnerable. Meanwhile, the higher US r-star compared to that of the rest of the world will continue to support higher yields in the US rather than in Europe or Japan. This phenomenon has been hugely positive for the US dollar, but it has likely run its course. Finally, global real interest rates remain below r-star estimates. Hence, the current slowdown is likely to prove to be a mid-cycle slowdown and Europe will rebound quickly from a potential recession caused by the recent surge in its energy prices. The ECB Joins The 75bps Club Last week, the ECB increased interest rates by 75bps, which brought its deposit rate to 0.75%. Interestingly, the euro did not rally much in response to this policy decision, even though it has not been fully discounted by the market. At first glance, the lack of responsiveness from European assets seems strange, especially since the vote for a 75bps rate hike was unanimous. The ECB is taking advantage of strong economic numbers to push up rates rapidly. The Eurozone Q2 GDP growth was robust at 0.6%, while the unemployment rate hit an all-time low of 6.6%. Meanwhile, inflation continues to beat consensus forecasts, with Eurozone core CPI and headline CPI standing at 4.3% and 9.1%, respectively in August. Chart 11Big ECB Revisions Big ECB Revisions Big ECB Revisions The market believes that more rapid interest rate hikes now will not translate into a much higher terminal rate, with the expected rates for June 2023 moving from 2.2% on September 7th to 2.4% after last Thursday’s decision. The ECB may have increased its inflation forecasts for the whole horizon, but it has also brought down GDP forecasts to 0.9% and 1.9% in 2023 and 2024, respectively (Chart 11). Moreover, ECB President Christine Lagarde went out of her way to telegraph to investors that the number of upcoming hikes was finite. The jumbo hike does not spell the start of a euro rally—for now. First, the lack of major change in the ECB’s terminal deposit rate is more important than the more rapid pace of hikes for the remainder of 2022. Second, the Fed is also lifting rates faster than investors expected ahead of the Jackson Hole meeting three weeks ago. Third, the euro remains vulnerable to any flare-ups in the energy market. True, natural gas and electricity prices have recently fallen, but the situation in Ukraine continues to be highly fluid, which suggests that volatility will linger in the energy market over the coming weeks.   Despite the near-term hurdles, the euro’s medium-term outlook is brightening. We are gaining confidence in our thesis that energy prices will peak once natural gas inventories have reached approximately 90% by November. Additionally, the support of the Governing Council’s doves for a 75bps hike suggests that they received something in exchange for their votes. In our view, this “something” is an activation of the Transmission Protection Instrument (TPI) before year-end. The TPI activation will allow for a normalization of the risk premia in the Italian debt market and will support the ECB’s ability to increase interest rates further down the road, despite the much lower r-star in Italy, Spain, and France than in Germany (Table 3). Table 3The Eurozone’s Different R-Stars Will Force The TPI’s Activation Neutral Rates Around The World Neutral Rates Around The World Bottom Line: The ECB may have delivered a jumbo hike last week, but its market impact was muted. Investors understand full well that the ECB is taking advantage of the recent bout of robust economic activity to front-load interest rate increases ahead of a likely economic contraction in Q4 2022 and Q1 2023. As a result, the terminal rate estimates have scarcely moved. Ultimately, we expect the ECB deposit rate to settle between 1.5% and 2% in the summer of 2023. While the move may not provide much of a boost to the euro in the near term, conditions are falling into place for a euro rally later this year.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1     For the US, we opted for core PCE, since it is the benchmark inflation measure the Federal Reserve uses.

Executive Summary Our negative view on the summer rally is coming to fruition, with equities falling back on the negative geopolitical, macro, and monetary environment. China is easing policy ahead of its full return to autocratic government this fall. Yet the Fourth Taiwan Strait Crisis has only just begun. Tensions can still deal nasty surprises to global investors. It is essential to verify that relations will thaw after the US midterm and Chinese party congress is critical. Russia continues to tighten energy supply as predicted. Ukraine’s counter-offensive is pushing back the time frame of a ceasefire deeper into next year. Putin may declare victory and quit while he is ahead – but Russia will not be forced to halt its invasion until commodity prices fall significantly. Sweden’s election will not interfere with its NATO bid; Australia’s new government will not re-engage with China; Malaysia’s election will be a positive catalyst; South Africa’s political risks are reawakening; Brazil’s risks are peaking; Turkey remains a leading candidate for a negative “black swan” event. China’s Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 17.4% Bottom Line: Investors should stay defensive in the short run until recession risks and geopolitical tensions abate. Feature Last week we visited clients across South Africa and discussed a broad range of global macro and geopolitical issues. In this month’s GeoRisk Update we relate some of the key points in the context of our market-based quantitative risk indicators. While we were traveling, US-Iran negotiations reached a critical phase. A deal is said to be “closer” but we remain pessimistic (we still give 40/60 odds of a deal). The important point for investors is that the supply side of global oil markets will remain tight even if a deal is somehow agreed, whereas it will get much tighter if a deal is not agreed. China’s rollout of 1 trillion yuan ($146 billion) in new fiscal stimulus and rate cuts (5 bps cut to 1-year Loan Prime Rate and 15 bps cut to 5-year LPR) is positive on the demand side and supports our key view in our 2022 annual outlook that China would ease policy ahead of the twentieth national party congress. However, it is still the case that China is not providing enough stimulus to generate a new cyclical rally. Second quarter US GDP growth was revised slightly upwards but was still negative. Russia tightened control of European energy, as expected, increasing the odds of a European recession. Europeans are getting squeezed by rising energy prices, rising interest rates, and weak external demand. China Eases Policy Ahead Of Return To Autocracy China is facing acute political risk in the short term but it is also delivering more stimulus to try to stabilize the economy ahead of the twentieth national party congress this fall (Chart 1). The People’s Bank of China cut the benchmark lending rate by (1-year LPR) by 5 basis points, while authorities unveiled fiscal spending worth 1 trillion renminbi. Chart 1China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk After the party congress, the regime is likely to “let 100 flowers bloom,” i.e. continue with a broad-based policy easing to secure the recovery from the Covid-19 shock. This will include loosening social restrictions and aggressive regulations against industrial sectors like the tech sector. It should also include some diplomatic improvements, especially with Europe. But it is only a short term (12-month) trend, not a long-term theme. Related Report  Geopolitical StrategyRoulette With A Five-Shooter China’s return to autocratic government under General Secretary Xi Jinping is a new, negative, structural factor and is nearly complete. Xi is highly likely to secure another decade in power and promote his faction of Communist Party stalwarts and national security hawks. The period around the party congress will be uncertain and dangerous. The exact makeup of the next Politburo could bring some surprises but there is very little chance that Xi and his faction will fail to consolidate power. The nomination of an heir-apparent is possible but of limited significance since Xi will not step down anytime soon or in a regular, predictable manner. Larger stimulus combined with power consolidation could spur greater risk appetite around the world, as it would portend a stabilization of growth and policy continuity. However, China’s underlying problems are structural. The manufacturing and property bust can be delayed but not reversed. China’s foreign policy will continue to get more aggressive due to domestic vulnerability, prompting foreign protectionism, export controls, sanctions, saber-rattling, and the potential for military conflict. Bottom Line: Investors should use any rally in Chinese assets over the coming 12 months as an opportunity to sell and reduce exposure to China’s historic confluence of political and geopolitical risk. Fourth Taiwan Strait Crisis Only Beginning The Fourth Taiwan Strait Crisis has only just begun. The previous three crises ranged from four to nine months in duration. The current crisis cannot possibly abate until November at earliest. Taiwan’s political risk will stay high and we would not buy any relief rally until there is a firm basis for believing tensions have fallen (Chart 2). Chart 2Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis If this year’s crisis were driven by US and Chinese domestic politics – the US midterm election and China’s party congress – then both Presidents Biden and Xi Jinping would already have achieved what they want and could proceed to de-escalate tensions by the end of the year – i.e. before somebody really gets hurt. The two leaders could hold a bilateral summit in Asia in November and agree to uphold the one China policy and status quo in the Taiwan Strait. We have given a 40% chance to this scenario, though we would still remain pessimistic about the long-term outlook for Taiwan. But if this year’s crisis is driven by a change in US and Chinese strategic thinking as a result of Russia’s invasion of Ukraine and China’s rising domestic instability, then there will not be a quick resolution on Taiwan. The crisis would grow next year, increasing the risk of aggression or miscalculation. We have given a 60% probability to this scenario, of which full-scale war comprises 20 percentage points. Bottom Line: Our geopolitical risk indicator for Taiwan spiked and Taiwanese equities rolled over relative to global equities as we expected. However, our oldest trade to capture the high long-term risk of a war in the strait – long Korea / short Taiwan – has performed badly despite the crisis. South Korea: China Stimulus A Boon But Not Geopolitics US-China rivalry – and the thawing of Asia’s once-frozen conflicts – is also manifest on the Korean peninsula, where the limited détente between the US and North Korea negotiated by President Donald Trump and Kim Jong Un has fallen apart. South Korea’s situation is not as risky as Taiwan’s but it is nevertheless less stable than it appears (Chart 3). Chart 3South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea resumed its full-scale joint military exercise with the US, the Ulchi Freedom Shield, from August 22 to September 1. The drills involve amphibious operations and a carrier strike group. Full-scale drills were scaled down or cancelled under the Trump and Moon Jae-In administrations with the hopes of facilitating diplomacy and reducing tensions on the peninsula. North Korea was to discontinue ballistic missile tests and threats to the United States. But after the 2020 election neither Washington nor Pyongyang considered itself bound by this agreement. This year the US went forward with Ulchi Freedom even though regional tensions were sky-high because of House Speaker Nancy Pelosi’s visit to Taiwan and the De-Militarized Zone in Korea. The US is flagging its regional interests and power bases. North Korea is increasing the frequency of missile tests this year and is likely to conduct an eighth nuclear test. On August 17, it fired two cruise missiles towards the Yellow Sea. Pyongyang does not want to be ignored amid so many other geopolitical crises. It is emboldened by the fact that Russia and China will not be voting with the US for another round of sanctions at the United Nations Security Council due to the war in Ukraine and tensions over Taiwan. On August 11, South Korea responded to China’s insistence that the new government should abide by the “Three No’s,” i.e. three negatives that the Moon administration allegedly promised China: no additional deployments of the US’s Terminal High-Altitude Area Defense (THAAD) system, no Korean integration into US-led missile defense, and no trilateral military alliance with the US and Japan. Korea’s Foreign Minister Park Jin told reporters upon his return from China that the three no’s were “neither an agreement nor a promise.” South Korea’s new and conservative President Yoon Suk-yeol is unpopular and gridlocked at home but he is using the opportunity to reassert Korean national interests, including the US military alliance. Tension with the North and cold relations with China are coming at a time when the economy is slowing down. Korean GDP grew by 0.7% in Q2 2022 on a quarter-on-quarter basis, supported by household and government spending, while exports and investments shrank. Roughly a quarter of Korean exports go to China, its biggest trading partner. Korean exports to China have suffered due to China’s economic woes but cold relations could bring new economic sanctions, as China has hit South Korea before over THAAD. With the Yoon administration planning to bring the fiscal deficit back to below 3% of GDP next year, and a broader backdrop of weak Chinese and global demand, it is hard to find bright corners in the Korean economy in the near term. With Yoon’s basement level approval rating, he will resort to foreign policy to try to revive his political capital. Saber rattling and tough talk with North Korea and China will increase tensions in an already hot region – geopolitical risk is bound to stay high on the back of the Taiwan crisis. Bottom Line: On a relative basis, due to the ironclad US security guarantee, South Korea is safer than Taiwan. Investors wanting exposure to Chinese economic stimulus, electric vehicles, and semiconductors should go long South Korea. But some volatility is likely because the North’s eighth nuclear test will occur in the context of high and rising regional tensions. Australia: Stimulus Is Positive But No “Thaw” With China Australia is blessed with strong geopolitical fundamentals but it is seeing a drop in national security and economic security due to the deterioration of China relations. Domestic political turmoil is one of the consequences (Chart 4). Most recently Australia has been roiled by the revelation that former Prime Minister Scott Morrison secretly ran five ministries during the pandemic: the ministries of Home, Treasury, Finance, Resources, and Health. Chart 4Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited After an investigation and review by the Solicitor General Stephen Donaghue, Morrison’s action was determined to be legal, although highly inappropriate and inconsistent with the principles of responsible governance. Morrison’s appointments to these ministries were approved by the Governor General but the announcement or publication of appointments has always been the prerogative of the government of the day. One might think that this investigation is merely politically motivated but the Solicitor General is an apolitical position unlike the Attorney General, and Donaghue had been serving with Morrison, guiding him about the constitutionality of a vaccine mandate during the pandemic. The new Labor Party government of Prime Minister Anthony Albanese has vowed to be more transparent and will seek to enshrine a transparency measure into the law. Its political capital will improve, which is helpful for its ability to achieve its chief election promises. With the change of the government, it was hoped that there would be a thaw in the Australia-China relationship. China is Australia’s largest export destination and it erected boycotts against certain Australian exports in 2020 in response to Prime Minister Morrison’s inquiry into the origin of Covid-19. Hence Australia’s new defense minister, Richard Marles, met with his Chinese counterpart, General Wei Fenghe, on the sideline of the Shangri-La Dialogue in Singapore in June, which rekindled the hope that a thaw might happen. Yet a thaw is unlikely for strategic reasons, as highlighted by the Fourth Taiwan Strait Crisis, the Biden administration’s retention of former President Trump’s tariffs, and Australia’s fears of China’s rising influence in the Pacific Islands. The US and Australia are preparing for a long-term policy of containing China’s ambitions. A few days after his election, Prime Minister Albanese flew to Tokyo to attend a meeting of the Quadrilateral Security Dialogue (the Quad), sending a signal that there will be policy continuity with respect to Australian foreign policy. On May 26, Chinese fighter jets flew closely to an Australian surveillance plane on its routine operation and released aluminum chaffs that were ingested by the P8’s engines. An Australian warship, the HMAS Parramatta, was tracked by a People’s Liberation Army nuclear power submarine and multiple aircrafts on its way back from Vietnam, Korea, and Japan as part of its regional presence deployment in June. Currently Australia is hosting the Pitch-Black military exercise, with 17 countries participating. This exercise will last for three weeks – focusing on air defense and aerial refueling. It will also see the German air force with 13 military aircrafts deployed to the Indo-Pacific region for the very first time. They will be stopping in Japan after the exercise. As Australia’s policy towards China is unlikely to change, geopolitical risk will remain elevated. On the economic front, Australia’s misery index is at the highest point since 2000, with an unemployment rate at 3% and inflation at 6%. GDP growth in the first quarter was 0.8% compared to 3.6% in Q4 2021, propped up by government and household consumption while investment and exports contracted. The good news for the government is that it is inheriting this negative backdrop and can benefit from cyclical improvements in the next few years. Since the Labor government lacks a single-party majority in the Senate (where it must rely on the Greens and independents), it will be difficult for the government to raise new taxes. So far, Albanese has indicated that the budget to be tabled in October will focus on pre-election promises, which includes childcare, healthcare, and energy reforms. At worst, Australian government spending will stay flat, but it is unlikely to shrink considering Labor’s narrow control of the House of Representatives. Australian equities have not outperformed those of developed market peers despite high industrial metal prices. The stock market’s weak performance is attributable to the stumbling Chinese economy (Chart 5). Australian exports to China in June are still down 14% from June of last year. Chinese economic woes will be a headwind to Aussie growth and equity markets until next year, when Chinese stimulus efforts reach their full effect. Chart 5Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices On the other hand, the value of Australian natural gas and oil exports in June grew by 118% and 211% respectively (Chart 6), compared to June of last year. Chart 6Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth ​​​​​ Bottom Line: As China will continue stimulating the economy and global energy markets will remain tight, investors should look for opportunities in Aussie energy and materials stocks. Malaysia Closes A Chapter … And Opens A Better One? Rarely do we get to revisit our positive outlook on Malaysia – a Southeast Asian state with an ability to capitalize on the US break-up with China. On August 23, the embattled ex-prime minister of Malaysia, Najib Razak, lost his final appeal at the Federal Court in Putrajaya after being found guilty in 2020 for abuse of power, criminal breach of trust, and money laundering tied to Malaysia’s sovereign wealth fund, 1MDB. The high court instructed that he serves his 12-years prison sentence immediately, becoming the first prime minister to be imprisoned in the country’s 60-years plus of history. Political risk has weighed on the Malaysian economy for almost a decade starting with the contentious 2013 general election, which saw the collapse of non-Malay voter support for the ruling party. Then came the 2015 Wall Street Journal bombshell about 1MDB, and then the 2018 general election that resulted in Malaysia’s first change of government since independence. The pandemic also led to political crisis in 2020. Each crisis resulted in a successive weakening of animal spirits and ever lower investments, resulting in Malaysia’s loss of competitiveness (Chart 7). Malaysia’s cheap currency was unable to increase its competitiveness, due to the low investments in the economy, and reflected higher political risks in the country (Chart 8). Chart 7Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness ​​​​​​ Chart 8Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk ​​​​​​ Nonetheless this entire saga has proved that Malaysia’s legal system is independent and that its political system is capable of holding policymakers accountable. The next general election will come in a matter of months and recent state elections bodes well for the institutional ruling party, the United Malay National Organization (UMNO), and its coalition, Barisan Nasional. The coalition is managing to claw back support from the Malay and non-Malay voters. The opposition had the bad luck of ruling during the pandemic and its rocky aftermath, which has helped to rehabilitate the traditional ruling party. We have long seen Malaysia as a potential opportunity. But we would advise investors to wait until the new election is held and a new government takes power before buying Malaysian equities. With the conclusion of its decade-long 1MDB saga, we would turn more bullish if the next election produces a sizeable and enduring majority, if the use of racial and sectarian rhetoric tones down, and if the governing coalition pursues pro-competitiveness policies. Bottom Line: Structurally, Malaysia is one of the largest exporters of semiconductors and will benefit from the US’s shift away from China and attempt to reconstruct supply chains so they run through the economies of allies and partners. Russia: Escalating To De-Escalate? Russia increased the number of active military personnel in a move that points to an escalation of the conflict with Ukraine and the West, even as Ukraine wages a counter-offensive against Russia in Crimea and elsewhere. The time frame for a ceasefire has been pushed further into next year. As long as the war escalates, European energy relief will be elusive. Our risk indicators will rise again (Chart 9). Chart 9Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Ukraine will not be able to drive Russians out of territory in which they are entrenched. It would need a coalition of western powers willing to go on the offense, which will not happen. Russia is also threatening to cut off the Zaporizhzhia nuclear power plant, ostensibly removing one-fifth of Ukraine’s electricity. Once the Ukrainian counter-offensive grinds to a halt, a stalemate will ensue, incentivizing ceasefire talks – but not until then. The Europeans will have to support Ukraine now but will become less and less inclined to extend the war as they get hit with recession. Russia says it is prepared for a long war but that kind of rhetoric is necessary for propaganda purposes. The truth is that Russia does not have great success with offensive wars. Russia usually suffers social instability in the aftermath. The best indicator for the duration of the war is probably the global oil price: If it collapses for any reason then Russia’s war machine will fall short of funds and the Kremlin will probably have to accept a ceasefire. This what happened in 2014-15 with the Minsk Protocols. Putin will presumably try to quit while he is ahead, i.e. complete the conquest and shift to ceasefire talks, while commodity prices are still supportive and Europe is economically weak. If commodity prices fall, Russia’s treasury dries up while Europe regains strength. So while military setbacks can delay a ceasefire, Russia should be seen as starting to move in that direction. The deal negotiated with Turkey and the United Nations to ship some grain from Odessa is not reliable in the short run but does show the potential for future negotiations. However, a high conviction on the timing is not warranted. Also, the US and Russia could enter a standoff over the US role in the war, or NATO enlargement, at any moment, especially ahead of the US midterm election. Bottom Line: Ukraine’s counteroffensive and Russia’s tightening of natural gas exports increases the risk to global stability and economic growth in the short run, even if it is a case of “escalating tensions in order to de-escalate” later when ceasefire talks begin. Italy: Election Means Pragmatism Toward Russia Italy’s election is the first large crack in the European wall as a result of Russia’s cutoff of energy. The party best positioned for the election – the right-wing, anti-establishment party called the Brothers of Italy – will have to focus on rebooting Italy’s economy once in power. This will require pragmatism toward Russian and its natural gas. Regardless of whether a right-wing coalition obtains a majority or the parliament is hung, Italian political risk will stay high in the short run (Chart 10). Chart 10Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Although the center-left Democratic Party (PD) is narrowing the gap with the Brothers of Italy in voting intentions, it is struggling to put together an effective front against the right-wing bloc. After its alliance with the centrist Azione party and +Europa party broke down, PD’s chance of winning has become even slimmer. Even if the alliance revives, the center-left bloc still falls short of the conservative parties. Together, the right-wing parties account for just 33% of voting intentions (Democrats at 23%, Greens and Left Alliance at 3%, Azione and +Europa at 7%). By contrast, the right-wing bloc has a significant lead, with 46% of the votes (Brothers of Italy at 24%, Lega at 14%, Forza Italia at 8%). They also have the advantage of anti-incumbency sentiment amid a negative economic backdrop. Unless some sudden surprises occur, a right-wing victory is expected, with Giorgia Meloni becoming the first female prime minister in Italy’s history. This has been our base case scenario for the past several months. But what does a right-wing government mean for the financial markets? In an early election manifesto published in recent weeks, the conservative alliance pledged full adhesion to EU solidarity and dropped their previous euroskepticism. This helps them get elected and is positive for investors. However, there are also clouds on the horizon: In the same manifesto, the right-wing parties pledged to lower taxes for families and firms, increase welfare, and crack down on immigration. These programs will add to Italy’s huge debt pile and eventually lead to conflicts with the ECB and other EU institutions. In the manifesto, they stated that if elected, they would seek to amend conditions of Italy’s entitlement to the EU Recovery Fund, as the Russia-Ukraine war has changed the context and priorities significantly. This could potentially put the EU’s grants and cheap loans at risk. Under the Draghi government, Italy has secured about 67 billion euros of EU funds. According to the schedule, Italy will receive a further 19 billion Euros recovery funds in the second half of 2022, if it meets previously agreed upon targets. The new government will try to accept the funds and then make any controversial policy changes. On Russia, the conservative parties claimed that Italy would not be the weak link within EU. They pledged respect for NATO commitments, including increasing defense spending. Both Meloni and her Brothers of Italy have endorsed sending weapons to support Ukraine. Still, we think that due to Italy’s historical link with Russia and the need to secure energy supplies, the new government would be more pragmatic toward Russia. On China, Meloni has stressed that Italy will look to limit China’s economic expansion if the right-wing alliance wins. She stated that “Russia is louder at present and China is quieter, but [China’s] penetration is reaching everywhere.” China will want to use diplomacy to curb this kind of thinking in Europe. Meloni also stated that she would not seek to pursue the Belt and Road Initiative pact that Italy signed with China in 2019. In short, we stand firm on our recommendation of underweighting Italian assets at least until a new government is formed. Europe Gets Its Arm Twisted Further The United Kingdom is going through a severe energy, water, and inflation crisis – on top of the long backlog at the National Health Service – as it stumbles through the aftermath of Covid-19 and Brexit. The Conservative Party’s leadership contest is a distraction – political risk will not subside after it is resolved. The new Tory leader will lack a direct popular mandate but the party will want to avoid an early election in the current economic context, creating instability. The looming attempt at a second Scottish independence referendum will also keep risks high, as the outcome this time may be too close to call (Chart 11). Chart 11UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High Germany saw Russia halt natural gas flows through Nord Stream 1 as the great energy cutoff continues. As we have argued since April, Russia’s purpose is to pressure the European economies so that they are more conducive to a ceasefire in Ukraine. Germany will evolve quickly and will improve its energy security faster than many skeptics expect but it cannot do it in a single year. The ruling coalition is also fragile, even though elections are not due anytime soon (Chart 12). Chart 12Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising France’s political risk will also remain high (Chart 13), as domestic politics will be reckless while President Emmanuel Macron and his allies only control 43% of the National Assembly in the aftermath of this year’s election (Chart 14). Chart 13France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany Chart 14Macron Will Focus On Foreign Policy Odds And Ends (A GeoRisk Update) Odds And Ends (A GeoRisk Update) Spain is likely to see its coalition destabilized and early elections, much like Italy this year (Chart 15). Chart 15Spain: Early Elections Likely Spain: Early Elections Likely Spain: Early Elections Likely Sweden, along with Finland, will be joining NATO, which became clear back in April. In this sense it is at the center of Russia’s conflict with the West over NATO enlargement, so we should take a quick look at the Swedish general election on September 11. Currently the left-wing and right-wing blocs are neck and neck in the polls. While the current Social Democrat-led government may well fall from power, Sweden’s new pursuit of NATO membership is unlikely to change. The right-wing parties in Sweden are in favor of joining NATO. The two parties that oppose NATO membership are the left-wing Green and Left Party. The Social Democrats were pro-neutrality until the invasion of Ukraine and since May have spearheaded Swedish accession to NATO. The pro-neutrality bloc currently holds 43 seats in the 349-seats Riksdag. It has a supply-and-confidence arrangement with the current government and is currently polling at 13%. If it was willing and able to derail Sweden’s NATO bid, it would already have happened. So the general election in Sweden is unlikely to stop Sweden from joining. However, Russia does not want Sweden to join and the entire pre- and post-election period is ripe for “black swan” risks and negative surprises. One thing that could change with the election is Sweden’s immigration policy. The Social Democrats are pro-immigration (albeit pro-integration), while the right-wing bloc is less so. Sweden has received a great many asylum seekers since the Syrian refugee crisis in 2015 and will be receiving more from Ukraine and Russia (Chart 16). Chart 16Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Our Foreign Exchange Strategist Chester Ntonifor points out that the increase in asylum seekers could augment Swedish labor force and increase its potential growth in the long run, while in the short run it could increase demand in the domestic economy. But an increase in demand could also exacerbate inflation in Sweden, especially considering how much the Riksbank is behind the curve vis-à-vis the ECB. Our European Investment Strategy recommends shorting EUR/SEK as Sweden is less vulnerable to Russian energy sanctions. Sweden produces most of its energy from renewable sources. Relative to Europe, Canada faces a much more benign political and geopolitical environment (Chart 17). However, within its own context, it will continue to see more contentious domestic politics as interest rates rise on a society with high household debt and property prices. The post-Covid-19 period will undermine the Justin Trudeau government over time, though it is not facing an election anytime soon. Canada continues to benefit from North America’s geopolitical advantage, though quarrels with China will continue, including over Taiwan, and should be taken seriously. Aside from any China shocks we expect Canadian equities to continue to outperform most global bourses. Chart 17Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy South Africa: The Calm Before The Storm South Africa’s economy remains in a low growth trap, which is contributing to rising political risk (Chart 18). Electricity shortages continue to dampen economic activity. Other structural issues like 33.9% unemployment, worsening social imbalances, and a split in the ruling party threaten to cause negative policy surprises. Chart 18South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk The South African economy has failed to translate growth outcomes into meaningful economic development, leaving low-income households (the median voter) increasingly disenfranchised, burdened, and constrained. Last year’s civil unrest was fueled by economic hardships that persist today. Without a significant and consistent bump to growth, social and political risks will continue to rise. Low-income households remain largely state dependent. Fiscal austerity has already begun to unwind, well before the 2024 election, in a bid to shore up support and quell rising social pressures (Chart 19). Chart 19South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote The fact that the social scene is relatively quiet for now should not be seen as a sign of underlying stability. For example, two of the largest trade unions led a nationwide labor strike last week – while we visited clients in the country! – but failed to “shut down” the country as advertised. Labor union constituents noted the ANC’s economic failures, demanded immediate economic reform, and advocated for a universal basic income grant. This action blew over but the election cycle is only just beginning. Looking forward to the election, President Cyril Ramaphosa’s ANC is still viewed more favorably than the faction led by ex-President Jacob Zuma, but Ramaphosa has suffered from corruption allegations recently that have detracted attention from his anti-corruption and reform agenda and highlighted the party’s shortcomings once again. The ANC’s true political rival, the far-left Economic Freedom Fighters (EFF), have so far failed to capitalize on the weak economic backdrop. The EFF is struggling with leadership battles, thus failing to attract as many soured ANC voters as otherwise possible. If the Economic Freedom Fighters refocus and install new leadership, namely a leader that better reflects the tribal composition of the country, the party will become a greater threat to the ANC. But the overall macro backdrop is a powerful headwind for the ANC’s ability to retain a parliamentary majority. Global macro tailwinds that supported local assets in the first half of the year are experiencing volatility due to China’s sluggish growth and now stimulus efforts. Cooling metals prices and slowing global growth have weighed on the rand and local equity returns. But now China is enacting more stimulus. China is South Africa’s largest trading partner, so the decision to ease policy is positive for next year, even though China’s underlying structural impediments will return in subsequent years. This makes it hard to predict whether South Africa’s economic context will be stable in the lead-up to the 2024 election. As long as China can at least stabilize in the post-pandemic environment in 2023, the ANC will not face as negative of a macro environment in 2024 as would otherwise be the case. Investors will need to watch the risk of political influence on the central bank. Recently the ANC resolved to nationalize the central bank. Nationalization is mostly about official ownership but a change in the bank’s mandate was also discussed. However, to change the bank’s mandate from an inflation target to an unemployment target, the ANC would need to change the constitution. Constitutional change requires a two-thirds vote in parliament, a margin the ANC does not hold. Constitutional change will become increasingly difficult if the ANC sheds more support in the 2024 general election, as expected. Bottom Line: Stay neutral on South Africa until global and Chinese growth stabilize. Political risk is rising ahead of the 2024 election but it is not necessarily at a tipping point. Brazil And Turkey: Election Uncertainty Prevails We conclude with two brief points on Brazil and Turkey, which both face important elections – Brazil immediately and Turkey by June 2023. Both countries have experienced different forms of instability as emerging middle classes face economic disappointment, which has led to political challenges to liberal democracy. Brazil – President Jair Bolsonaro’s popular support is rallying into the election, as expected, but it would require a large unexpected shift to knock former President Lula da Silva off course for re-election this October (Chart 20). Brazil’s first round vote will be held on October 2. If Lula falls short of the 50% majority threshold, then a second round will be held on October 30. Bolsonaro faces an uphill battle because his general popularity is weak – his support among prospective voters stands at 35% compared to Lula at 44% today and Lula at 47% when he left office in 2010. Meanwhile the macroeconomic backdrop has worsened over the course of his four-year term. Bolsonaro will contest the election if it is close so Brazil could face significant upheaval in the short run. Chart 20Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Turkey – President Recep Erdogan’s approval rating has fallen to 41%, while his disapproval has risen to 54%. It is a wonder his ratings did not collapse sooner given that the misery index is reaching 88%, with headline inflation at 78%. Having altered the constitution to take on greater presidential powers, Erdogan will do whatever it takes to stay in power, but the tide of public opinion is shifting and his Justice and Development Party is suffering from 21 years in power. Erdogan could interfere with NATO enlargement, the EU, Syria and refugees, Greece and Cyprus, North Africa and Libya, or Israel in a way that causes negative surprises for Turkish or even global investors. Turkey will be a source of “black swan” risks at least until after the general election slated for June 2023 (Chart 21). Chart 21Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' We will revisit each these markets in greater detail soon. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com ​​​​​​​Yushu Ma Research Analyst yushu.ma@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Listen to a short summary of this report.     Executive Summary Chart 1The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Before The First Line Of Support The Dollar Has Broken Before The First Line Of Support The softer CPI print in the US boosted growth plays and pushed the DXY index below its 50-day moving average (Feature Chart). This suggests CPI numbers will remain the most important print for currency markets in the coming weeks and months. If US inflation has peaked, then the market will price a less aggressive path for Fed interest rates, which will loosen support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation. This will keep them on a tightening path. This puts the DXY in a tug of war. On the downside, the Fed could turn less hawkish. On the other hand, currencies such as the EUR, GBP and even SEK face high inflation but deteriorating growth. This will depress real rates. Within this context, the most attractive currencies are those with relatively higher real rates, and a real prospect of a turnaround in growth. NOK and AUD stand out as potential candidates. Our short EUR/JPY trade has been performing well in this context. Stick with it.  RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 141.20 2022-07-21 3.29 Bottom Line: Our recommended strategy is a neutral dollar view over the next three months, until it becomes clear inflation has peaked and global growth has bottomed. Feature The DXY index peaked at 108.64 on July 14 and has dropped to 105.1 as we go to press. There have been two critical drivers of this move. First, the 10-year US Treasury yield has fallen from 3.5% to 2.8%. With this week’s all important CPI release, which showed a sharp deceleration in the headline measure, bond yields may well stabilize at current levels for a while. Second, the drop in energy prices has boosted the JPY, SEK and EUR, which are heavily dependent on imported energy. Related Report  Foreign Exchange StrategyA Montreal Conversation On FX Markets Another development has been happening in parallel – as US inflation upside surprises have crested, so has the US price impulse relative to its G10 counterparts (Chart 1). To the extent that this eases market pricing of a hawkish Fed (relative to other G10 central banks), it will continue to diminish upward pressure on the dollar. Much will depend on the incoming inflation prints both in the US, and abroad. With the DXY having broken below its 50-day moving average, the next support level is at 103.6. This is where the 100-day moving average lies, which the dollar tested twice this year before eventually bouncing higher (Chart 2). The next few sections cover the important data releases over the last month in our universe of G10 countries, and implications for currency strategy. What is clear is that most foreign central banks are committed to their tightening campaign, which argues for a neutral stance towards the DXY for now. Chart 1US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over Chart 2The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support US Dollar: Consolidation Chart 3The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The dollar DXY index is up 10% year to date. Over the last month, the DXY index is down 2.1% (panel 1). Incoming data continues to make the case for a strong dollar. Job gains are robust. In June, the US added 372K jobs. The July release was even stronger at 528K jobs. This pushed the unemployment rate to a low of 3.5% (panel 2). Wages continue to soar. Average hourly earnings came in at 5.2% year-on-year in July. The Atlanta Fed wage growth tracker continues to edge higher across all income cohorts (panel 3). The June CPI print was above expectations at 9.1% for headline, with core at 5.9%. The July print for headline that came out this week was 8.5%, below expectations of 8.7%. At 5.9%, the core measure is still well above the Fed’s target (panel 4). June retail sales remained firm, but consumer sentiment continues to weaken. While the University of Michigan current conditions index increase from 53.8 to 58.1 in June, this is well below the January 2020 level of 115. Correspondingly, the Conference Board consumer confidence index fell from 98.7 to 95.7 in July. On June 17, the Fed increased interest rates by 75bps, as expected. The US entered a second consecutive quarter of GDP growth contraction in Q2, falling by an annualized 0.9%. The ISM manufacturing index was flat in July suggesting Q3 GDP is not starting on a particularly strong foot. The Atlanta Fed Q3 GDP growth tracker is, however, printing 2.5%. Unit labor costs are soaring, rising 10.8% in Q2. This is sapping productivity growth, which fell 4.6% in Q2.  The key for the dollar’s outlook is the evolution of US inflation and the labor market. For now, inflation remains sticky, and wages are rising. Meanwhile, labor market conditions remain robust. This will keep the Fed on a tightening path in the near term. We initially went short the DXY index but were stopped out. We remain neutral in the short term, though valuation keeps us bearish over a long-term horizon. The Euro: A European Hard Landing Chart 4The Euro Is At Recession Lows The Euro Is At Recession Lows The Euro Is At Recession Lows The euro is down 9.2% year to date. Over the last month, the euro is up 2.7%, having faced support a nudge below parity. Incoming data continues to suggest weak economic conditions, with a stagflationary undertone: The ZEW Expectations Survey for July was at -51.1, the lowest reading since 2011 (panel 1). The current account remains in a deficit, at -€4.5bn in May. Consumer confidence continues to plunge. The July reading of -27 is the worst since the 2020 Covid-19 crisis (panel 2). Despite the above data releases, the ECB surprised markets by raising rates 50bps. CPI continues to surprise to the upside. The preliminary CPI print for July came in at 8.9%, well above the previous 8.6% print. PPI in the euro area was at 35.8% in June, a slight decline from the May reading (panel 3). The German Ifo business expectations index fell to 80.3 in July. Historically, that has been consistent with a manufacturing PMI reading of 45 (panel 4). The Sentix confidence index stabilized in August but remains very weak at -25.2. This series tends to be trending, having peaked in July last year. We will see if the next few months continue to show stabilization. The ECB mandate dictates that it will continue to fight soaring inflation. As such, it may have no choice but to generate a Eurozone-wide recession. This is the key risk for the euro since it could push EUR/USD below parity again. We continue to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a risk-on environment, like this week, the yen can still benefit since it is oversold. Meanwhile, investors remain overwhelmingly bearish (panel 5). The Japanese Yen: Quite A Hefty Rally Chart 5Some Green Shoots In Japan Some Green Shoots In Japan Some Green Shoots In Japan The Japanese yen is down 13.4% year-to-date, the worst performing G10 currency (panel 1). Over the last month, the yen is up 3.3%. Incoming data in Japan has been worsening as the rising number of Covid-19 cases is hitting mobility and economic data. According to the Eco Watcher’s survey, sentiment among small and medium-sized Japanese firms deteriorated in July. Current conditions fell from 52.9 to 43.8. The outlook component also declined from 47.6 to 42.8. Machine tool order momentum, one of our favorite measures of external demand, continues to slow. Peak growth was at 141.9% year-on-year in May last year. The preliminary reading from July was at 5.5% (panel 2). Labor cash earnings came in at 2.2% year-on-year, a positive sign. Household spending also rose 3.5%. Rising wages could keep inflation momentum rising in Japan (panel 3). On that note, the Tokyo CPI report for July was also encouraging, with an increase in the core-core measure from 1% to 1.2%. The Tokyo CPI tends to lead nationwide measures. The labor market remains robust. Labor demand exceeds supply by 27%. The Bank of Japan kept monetary policy on hold on July 20th, a policy move that makes sense given incoming data. The BoJ still views a large chunk of inflation in Japan as transitory. For inflation to pick up, wages need to rise. While they are rising, inflation expectations remain well anchored, suggesting little rationale for the BoJ to shift (panel 4). That said, the yen is extremely cheap after being the best short this year (panel 5).  British Pound: Coiled Spring Below 1.20? Chart 6Cable Is Vulnerable Cable Is Vulnerable Cable Is Vulnerable The pound is down 9.8% year to date. Over the last month, the pound is up by 2.5%. Sterling broke below a soft floor of 1.20, but quickly bounced back and is now sitting at 1.22, as sentiment picked up (panel 1). We find the UK to have an even bigger stagflation problem than the eurozone. CPI came in at 9.4% in June. The RPI came in at 11.8%. PPI was at 24%. All showed an acceleration from the month of May (panel 2). Nationwide house price inflation has barely rolled over unlike other markets, increasing from 10.7% in June to 11% in July. The Rightmove national asking price was 9.3% higher year-on-year in July, compared to 9.7% in June (panel 3). Meanwhile, mortgage approvals have been in steady decline over the last two years, which points toward stagflation. Retail sales excluding auto and fuel fell 5.9% year-on-year in June, the weakest reading since the Covid-19 crisis. Consumer confidence is lower than in 2020 (panel 4). Trade data continues to be weak, which has dipped the current account towards decade lows (panel 5). The external balance is the biggest driver of the pound, given the huge deficit. The above environment has put the BoE in a stagflationary quagmire. Last week, they raised rates by 50 bps suggesting inflation is a much more important battle than growth. Politically, the resignation of Prime Minister Boris Johnson, and broader difficulties for the Conservative Party, is fueling sterling volatility. We are maintaining our long EUR/GBP trade as a bet that at 1.03, the euro has priced in a recession (well below the 2020 lows), but sterling has not. On cable, 1.20 will prove to be a long-term floor but it will be volatile in the short term.  Australian Dollar: A Contrarian Play Chart 7Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia The AUD is down 2.3% year-to-date. Over the last month, the AUD is up 5.3%. AUD is fast approaching its 200-day moving average. If that is breached, it could signal that the highs of this year, above 76 cents, are within striking distance (panel 1). Inflation is accelerating in Australia. In Q2, the inflation reading was 6.1%, while the trimmed-mean and weighted-median measures were above the central bank’s 1-3% band (panel 2). As a result, the RBA stated the benchmark rate was “well below” the neutral rate. It increased rates by an additional 50bps in August, lifting the official cash rate to 1.85%. Further rate increases are likely. There are a few reasons for this. First, labor market conditions are the most favorable in decades. In June, unemployment reached 3.5%, its lowest level in 50 years, against a consensus of 3.8% (panel 3). The participation rate also increased to 66.8% in June from 66.7%, which has pushed the underutilization rate to multi-decade lows (panel 4). Despite this, consumer confidence continued its decline in August, dropping to 81.2 from 83.8. A pickup in Covid-19 cases and high consumer prices are the usual suspects. Beyond the labor market, monetary policy seems to be having the desired effect. Demand appears to be slowing as retail sales grew 0.2% month-on-month in June from 0.9%. Home loan issuance declined by 4.4% in June, driven by a 6.3% decline in investment lending. House price growth continued to decline in July, particularly in densely populated regions like Sydney and Melbourne. The manufacturing sector remains strong, with July PMI coming in at 55.7, suggesting the RBA might just be achieving a soft landing in Australia.  The external environment was largely favorable for the AUD in June, as the trade balance increased substantially by A$17.7bn with commodities rallying early in the month. However, commodity prices are rolling over. The price of iron for example, is down 24% from its peak in June. This will likely weigh on the trade balance going forward (panel 5). A weakening external environment are near-term headwinds for the AUD, but we will be buyers on weakness (panel 6).  New Zealand Dollar: Least Preferred G10 Currency Chart 8Near-Term Risks To NZD Near-Term Risks To NZD Near-Term Risks To NZD The NZD is down 6.1% this year. Over the last month, it is up 5% (panel 1). The Reserve Bank of New Zealand raised its official cash rate (OCR) in July by 50bps to 2.5%, in line with market expectations. Policymakers maintained their hawkish stance and guided towards increased tightening until monetary conditions can bring inflation within its target range of 1-3%. Inflation rose in Q2 to 7.3% from a 7.1% forecast, largely driven by rising construction and energy prices (panel 2). As of the latest data, monetary policy appears to be continuing to have the desired effect on interest rate sensitive parts of the economy. REINZ home sales declined 38.1% year-on-year in June. Home price growth continues to roll over (panel 3). The external sector continues to slow. Dairy prices, circa 20% of exports, saw a 12% drop in early August after remaining flat in July. The 12-month trailing trade balance remains in deficit. This is most likely due to a substantial slowdown in Chinese economic activity, given that China is an important trade partner with New Zealand. What is important is that the RBNZ’s “least regrets” approach seems to be working. Despite a cooling economy, sentiment seems to be stabilizing. ANZ consumer confidence improved to 81.9 in July from 80.5. Business confidence also improved to -56.7 from -62.6 (panel 4). Ultimately, the NZD is driven by terms of trade, as well as domestic conditions (panels 1 and 5). Thus, short-term headwinds from a deteriorating external sector do not make us buyers of the currency for now, though a rollover in the dollar will help the kiwi.  Canadian Dollar: Lower Oil, Hawkish BoC Chart 9The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The CAD is down 1.2% year to date. Over the last month, it is up 1.8%. The Canadian dollar did not fully catch up to oil prices on the upside. Now that crude is rolling over, CAD remains vulnerable, unless the dollar continues to stage a meaningful decline (panel 1). Canadian data has been rather mixed over the last month. For example: There have been two consecutive months of job losses. This is after a string of positive job reports. In July, Canada lost 31K jobs. In June, it lost 43K. The reasons have been mixed, from women dropping out of the labor force, to lower youth participation (the participation rate fell), but this is a trend worth monitoring (panel 2). CPI growth remains elevated and is accelerating both on headline and core measures(panel 3). Building permits and housing starts have started to roll over, as house price inflation continues to lose momentum. June housing starts were at 274K from 287.3K. June building permits also fell 1.5% month-on-month though annual inflation is still outpacing house price growth (panel 4). The Canadian trade balance is improving, hitting a multi-year high of C$5.05 bn in June. This has eased the need for foreign capital inflows. The BoC raised rates 100bps in July, the biggest interest rate increase in one meeting among the G10. Unless the labor market continues to soften, the BoC will continue to focus on inflation, which means more rate hikes are forthcoming. The OIS curve is pricing a peak BoC rate of 3.6% in 9 months (panel 5). Two-year real rates are still higher in the US compared to Canada. And the loonie has lost the tailwind from strong WCS oil prices. As such, unless the dollar softens further, the loonie will remain in a choppy trading pattern like most of this year.  Swiss Franc: A Safe Haven Chart 10The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now CHF is down 3.2% year-to-date and up 4.3% in the past month. The Swiss franc has been particular strong against the euro, with EUR/CHF breaching parity (panel 1). Switzerland remains an island of relative economic stability in the G10. Although slowing, the manufacturing PMI was a healthy 58 in July. The trade surplus was up to CHF 2.6bn in June, despite a strong franc. While most European countries are preparing for a tough winter with energy rationing, prospects for Switzerland, which derives only 13% of its electricity from natural gas, look more favorable.  Still, as a small open economy, Switzerland is feeling the impact of global growth uncertainty. The KOF leading indicator dropped to 90.1 in August with a sharp decline in the manufacturing component. This broader measure suggests the relative resilience of the manufacturing sector might not last long (panel 2). Consumer confidence also fell to the lowest level since the onset of the pandemic. Swiss headline inflation stabilized at 3.4% in July. The core measure rose slightly to the SNB’s 2% target (panel 3). The UBS real estate bubble index rose sharply in Q2, suggesting inflation is not only an imported problem. Labor market conditions also remain tight, with the unemployment rate at 2%, a two-decade low. The SNB will continue to embrace currency strength while inflation risks persist (panel 4), as can be seen by the decline in sight deposits and FX reserves (panel 5). The market is still pricing in another 50 bps hike in September although August inflation data that comes out before the meeting will likely be critical for that decision. CHF is one of the most attractive currencies in our ranking. Despite the recent outperformance, CHF is still down year-to-date against the dollar. A rise in safe-haven demand, and a possible energy crunch in winter will be supportive, especially against the euro.  Norwegian Krone: Oil Fields Are A Jewel Chart 11NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK is down 7.4% year-to-date and up 7.1% over the last month. It is also up 4.2% versus the euro, despite softer oil prices (panel 1). Inflation in Norway continues to accelerate. In July, CPI grew 6.8% year-on-year, above the market consensus and the Norges Bank’s forecast. Underlying inflation jumped sharply to an all-time high of 4.5%, compared to the Bank’s 3.2% forecast made just over a month ago (panel 2). These figures are adding pressure on the central bank to increase the pace of interest rate hikes, with 50bps looking increasingly likely at the meetings in August and September. NOK jumped on the inflation news. The housing market is starting to show signs of slowing with prices down 0.2% on the month in July, the first decrease since December. This, together with household indebtedness (panel 3), makes the task of policy calibration challenging. Our bias is that a persistently tight labor market and strong wage growth (panel 4) will allow the bank to focus on inflation. Economic activity remains robust in Norway but is softening. The manufacturing PMI fell to 54.6 in July, while industrial production was down 1.7% month-over-month in June. Consumer demand remains frail with retail sales and household consumption flat in June from the previous month. On a more positive note, trade surplus remains near record levels and is likely to stay elevated as high European demand for Norwegian energy is likely to last at least through the winter (panel 5). As global risk sentiment picked up, the krone became the best performing G10 currency over the past month. If the risk appetite reverses, the currency is likely to feel some turbulence. Swedish Krona: Cheap, But No Catalysts Yet Chart 12SEK = EUR On Steroids SEK = EUR On Steroids SEK = EUR On Steroids SEK is down 10% year-to-date and up 5.6% over the past month. The vigorous rebound highlights just how oversold the Swedish krona is (panel 1). The Swedish economy grew 1.4% in Q2 from the previous three months, rebounding from a 0.8% contraction in the first quarter. This is impressive, given high energy prices and a slowdown in global economic activity. Going forward, growth is likely to slow. In July, the services and manufacturing PMIs declined, and consumer confidence fell sharply to the lowest reading in almost 30 years. Retail sales were down 1.2% month-on-month in June. The housing market is also feeling the pain of rising borrowing costs (panel 2). The Riksbank’s latest estimate sees a 16% decline in prices by the end of next year.  For now, inflation is still accelerating in Sweden. CPIF, the Riksbank’s preferred measure, increased from 7.2% to 8.5% in June. Headline inflation rose from 7.3% to 8.7% (panel 3). Headline inflation is likely to decline in July, given the drop in the price component of the PMIs, but inflation will remain well above target. This will keep real rates weak (panel 4). This suggests that the Riksbank is facing the same conundrum as the ECB: accelerate policy tightening and tip the economy towards recession or remain accommodative and risk inflation becoming more entrenched. Our bias is that the Riksbank is likely to frontload rate hikes as currently priced in the OIS curve, with a 50 bps hike in September, ahead of major labor union wage negotiations (panel 5). Much like the NOK, the Swedish krona rebounded strongly in the past month on global risk-on sentiment. Fundamentally, the krona remains more vulnerable to external shocks due to higher energy dependency and a strong dollar. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets.  The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end.  In February 2023, another 800k b/d of refined products will be embargoed.  December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term.  Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months.  The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented.  A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil.  Even so, oil balances still will remain tilted to deficit conditions in 2023.  We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 5Energy Driving High US Prices Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 7…And Refining Capacity Are Bullish For Petrol Products Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps.   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 The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 10 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over     Footnotes 1     Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2     Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3    Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022.  According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d.  In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4    Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5    Please see footnote #4. 6    The background factor in this situation is Russia’s involvement in Libya’s civil disorder.  We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7     Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8    Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9    Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10   After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11    Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12    For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis     Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Policymakers must continue engineering higher real interest rates, and tighter financial conditions, to help cool off growth and bring down overshooting inflation. This will inevitably lead to inverted yield curves across most of the developed world, following the recent trend of US Treasuries. US growth expectations remain overly pessimistic, which opens up the potential for more near-term bond-bearish upside data surprises like the July employment and ISM Services reports. The Bank of England – under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months. Bottom Line: Stay overweight UK Gilts versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in both countries. The Fed and Bank of England are both on course to push monetary policy into restrictive, growth-damaging territory. Don’t Get TOO Comfortable Taking Risk In a bit of a summer surprise, global financial markets have been staging a mild recovery from the stagflationary doom that prevailed during the first half of 2022. In the US, the S&P 500 index is up 14% from the year-to-date intraday low reached on June 16, with the VIX index back down to low-20s zone last seen in April (Chart 1). High-yield corporate bond spreads in the US and euro area are down 97bps and 36bps, respectively, since that mid-June trough in US equities. Even emerging market equities and credit – the most unloved of asset classes in 2022 – have stabilized. Related Report  Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts Some of this risk rally is surely short-covering, but there are some valid reasons to be less pessimistic on growth-sensitive risk assets. In the US, where the back-to-back contractions in GDP in the first two quarters of the year have stoked recession fears, the latest data releases have seen upside surprises suggesting an expanding, not contracting, economy (Chart 2). The July ISM non-manufacturing (services) index rose +1.4 points in July to 56.7, a broad-based move that included increases in Production, New Orders and New Export Orders. Core durable goods orders rose +0.5% in June for the second straight month. The biggest surprise was the July Payrolls report, which showed a whopping +528,000 increase in employment – over twice the expected gain of +250,000 – with a downtick in the unemployment rate to 3.5%. Chart 1Stepping Back From The Recessionary Abyss Stepping Back From The Recessionary Abyss Stepping Back From The Recessionary Abyss ​​​​​​ Chart 2The US Recession Talk May Have Been Premature The US Recession Talk May Have Been Premature The US Recession Talk May Have Been Premature ​​​​​​ Chart 3Goods Inflation Pressures Easing Goods Inflation Pressures Easing Goods Inflation Pressures Easing There was also some good news on the inflation front in the latest US data. The Prices Paid components of both the ISM manufacturing and non-manufacturing indices showed big declines, 18.5pts and 7.8pts respectively, in July, continuing the downtrends that began in the latter half of 2021 (Chart 3). This is not just a US story. The Prices Paid components of the S&P Global manufacturing PMIs in the euro area, the UK, Japan and China have also been falling. Lower global commodity prices, particularly for oil, are playing a large role in the pullback in reported business input costs. The Supplier Deliveries components of both ISM reports also fell on the month, continuing a trend seen throughout 2022 as global supply chain pressures have eased. Combined with the drop in the Prices Paid data, global PMIs are sending a strong message - inflationary pressures on the traded goods side of the global economy are finally easing. Slower goods inflation, however, does not provide an all-clear for risk assets on a cyclical basis. Non-goods price pressures are showing little sign of peaking across most of the developed world. Labor markets remain tight, and both wage inflation and services inflation rates continue to accelerate in the major economies of the US, UK and euro area at a pace well above central bank inflation targets (Chart 4). Until these domestic sources of inflation show signs of peaking, central banks will continue to push up policy rates to slow growth, generate higher unemployment and, eventually, bring domestically driven inflation back down to central bank targets. Expect the so-called Misery Index, summing headline inflation and the unemployment rate, to remain elevated across the major developed economies until negative real interest rates begin to rise through a combination of more nominal rate hikes and, eventually, slower inflation (Chart 5). Chart 4Domestic Inflation Pressures Accelerating Domestic Inflation Pressures Accelerating Domestic Inflation Pressures Accelerating ​​​​​ Chart 5Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise ​​​​​​As we discussed in last week’s report, bond markets were getting way ahead of themselves in pricing in aggressive rate cuts in 2023, especially in the US. This was setting up for a potential move higher in yields on any positive data news. Within the “Big 3” developed economies, US Treasuries look most vulnerable to a rebound in bond yield momentum, judging by what looks like a true bottom in the mean-reverting Citigroup US Data Surprise Index (Chart 6). The flow of data surprises is more mixed in the euro area and UK and is not yet at the stretched extremes that would signal a sustainable increase in bond yields. Taken at face value, this fits with our current recommendation to underweight the US, and overweight core Europe and the UK, within global government bond portfolios. With central banks now on track to push policy rates into restrictive territory, there is the potential for additional flattening of already very flat yield curves across the Big 3. Forward rates are not priced for additional curve flattening in those markets, looking at both the 2-year/10-year and 5-year/30-year government bond curves (Chart 7). This makes positioning for more curve flattening in the US, UK and euro area a positive carry trade by leaning against the pricing of forward rates. Chart 6Greater Potential For Bond-Bearish Data Surprises In The US Greater Potential For Bond-Bearish Data Surprises In The US Greater Potential For Bond-Bearish Data Surprises In The US ​​​​​​ Chart 7Increase Exposure To Curve Flattening In The 'Big 3' Increase Exposure To Curve Flattening In The 'Big 3' Increase Exposure To Curve Flattening In The 'Big 3' We are adjusting the positioning within the BCA Research Global Fixed Income Strategy Model Bond Portfolio this week to benefit from the trend towards additional curve flattening in the US, the UK and core Europe (Germany and France). With the 2-year/10-year curve already inverted by -45bps in the US, we see better value by adding flattening exposure between the 5-year and 30-year points – a curve segment that is not yet in inversion. In the UK and euro area, we see a case for positioning for flattening across the entire yield curve. Bottom Line: Stay overweight both UK Gilts and core European government bonds versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in all countries. The Fed and Bank of England are both clearly on course to push monetary policy into restrictive, growth-damaging territory, and the ECB may be forced to do the same. Painful Honesty From The Bank Of England The Bank of England (BoE) delivered its largest rate hike since 1995 last week, raising Bank Rate by 50bps to 1.75%. Planned sales of UK Gilts accumulated by the BoE during the quantitative easing phase of pandemic stimulus, at a pace of £10bn per quarter starting in September, were also announced. While those moves were largely expected by markets, the BoE’s new set of economic forecasts contained quite a shocker – an expectation of recession starting in Q4 of this year, running through the end of 2023 (Chart 8). The UK unemployment rate is expected to rise substantially from the current 3.8% to 6.3% by Q3/2025. Chart 8Brutal Honesty In The Latest BoE Forecasts Brutal Honesty In The Latest BoE Forecasts Brutal Honesty In The Latest BoE Forecasts ​​​​​​ Chart 9Energy Prices Driving BoE Inflation Forecasts Energy Prices Driving BoE Inflation Forecasts Energy Prices Driving BoE Inflation Forecasts We are hard pressed to remember the last time a major central bank announced a forecast of a prolonged economic downturn as part of its baseline scenario to bring inflation to its target. Such is the predicament that the BoE finds itself in, with headline UK inflation expected to soar to 13% by the end of 2022 – a mere 11 percentage points above the central bank’s inflation target. The BoE has been forced to sharply ratchet up that expected peak in UK inflation at both the May and August policy meetings this year. This is largely due to the massive increase in UK energy prices with the Energy component of the UK CPI index up over 50% in year-over-year terms. According to analysis published in the BoE August 2022 Monetary Policy Report, the direct impact of higher energy prices was projected to account for roughly half of that expected 13% peak in UK inflation this year (Chart 9). At the same time, falling energy prices embedded into futures curves are expected to full unwind that effect in 2023. The BoE’s recession call is also conditioned on a market-implied path for interest rates, with a 2023 peak in Bank Rate of just over 3% priced into the UK OIS curve. Looking beyond the energy price surge, there are signs that the BoE will not have to tighten as aggressively as interest rate markets are currently expecting. Our BoE Monitor, constructed using growth, inflation and financial market variables that would typically pressure the central bank to tighten or loosen monetary policy, has clearly peaked (Chart 10). All three components of the Monitor have rolled over, although inflation pressures remain the strongest contributor to the elevated absolute level of the Monitor. From a growth perspective, there are many reasons to expect the UK economy to enter a recession without much more prodding from BoE rate hikes (Chart 11): Chart 10Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates ​​​​​​ Chart 11A Broad-Based Slowing Of UK Growth A Broad-Based Slowing Of UK Growth A Broad-Based Slowing Of UK Growth ​​​​​​ Both the S&P Global manufacturing and services PMIs are on target to soon fall below the 50 level that indicates positive growth (top panel) Consumer confidence has collapsed as surging inflation has overwhelmed household income growth, leading to a contraction in retail sales volume growth (middle panel) The BoE’s Agents’ Survey of individual businesses shows a sharp deterioration in business investment spending plans (bottom panel). Yet even with growth clearly slowing already, the sheer magnitude of the inflation overshoot is forcing markets to discount a fairly aggressive path for UK interest rates over the next year. This is not only evident in the OIS curve, but also in the BoE’s own Market Participants Survey (MPS) of UK investors. According to the just released August MPS, the median expectation is for Bank Rate to peak at 2.5% next year (Chart 12). This is a sizeable increase from the previous expected peak of 1.75% from the last MPS in May, but is still below the discounted peak in rates from the OIS curve of 3.1%. The bigger news is that the, according to the August MPS, the median survey participant now believes that the neutral range for Bank Rate is now 2-2.5%, up from the 1.5-2.0% range in the May MPS. Therefore, the August MPS forecasted peak Bank Rate of 2.5% is only at the high end of neutral and not restrictive. Yet both the OIS curve and the August MPS expect the BoE to immediately pivot from rate hikes to rate cuts in the second half of 2023. Chart 12UK Interest Rate Markets Have Adjusted Neutral Rate Expectations UK Interest Rate Markets Have Adjusted Neutral Rate Expectations UK Interest Rate Markets Have Adjusted Neutral Rate Expectations Chart 13The BoE Is Facing Severe Public Scrutiny The BoE Is Facing Severe Public Scrutiny The BoE Is Facing Severe Public Scrutiny The notion that the BoE would pivot so quickly next year, when their own forecasts still call for UK inflation to be over 9% in the third quarter of 2023, seem somewhat optimistic. Especially with the BoE under tremendous public and political pressure because of runaway UK inflation. The leading candidate to become the next UK Prime Minister, Foreign Secretary Liz Truss, has already gone on record stating that she would look to change the BoE’s remit as Prime Minister to focus solely on keeping inflation low. Meanwhile, the latest BoE Inflation Attitudes Survey shows more respondents are now dissatisfied with the BoE than satisfied (Chart 13). 1-year-ahead inflation expectations from that same survey are now at 4.6%, while 5-year/5-year forward breakevens from UK index-linked Gilts are still at 3.8%. With inflation expectations still so elevated, and with the BoE’s own forecasts calling for headline UK inflation to not fall back to the 2% BoE target until Q3/2024, it is unlikely that the BoE will revert to rate cuts as quickly as markets expect – especially given the accelerating wage dynamics in the UK labor market. According to the BoE’s measure of “underlying” wage growth, which adjusts headline wage inflation data for pandemic effects from furloughs and shifting labor composition, wages are growing at a 4.2% year-over-year rate (Chart 14). The BoE’s own modeling work indicates that 2.9 percentage points of that wage growth is due to the level of short-term inflation expectations, with only 0.9 percentage points coming from productivity growth. Thus, the BoE cannot let its foot off the monetary brake until short-term inflation expectations fall substantially from current elevated levels – especially with employment indicators still pointing to a very tight supply-constrained, post-COVID UK labor market. Chart 14A Wage-Price Spiral In The UK? Misery Loves Company Misery Loves Company Given that interplay of rising headline inflation, elevated inflation expectations and tight labor markets, the BoE will likely be forced to begin unwinding the current rate hiking cycle later than markets expect. This will eventually lead to an inversion of the UK Gilt yield curve as the BoE pushes policy rates to restrictive territory and the UK economy falls into recession faster than other countries (like the US). Chart 15Stay Overweight UK Gilts, With A Curve Flattening Bias Stay Overweight UK Gilts, With A Curve Flattening Bias Stay Overweight UK Gilts, With A Curve Flattening Bias We still believe that the Fed is more likely than the BoE to fully follow through on market-discounted rate hikes over the next year, which was a major reason why we upgraded our cyclical recommendation on UK Gilts to overweight back in May. However, with the BoE now under more pressure to wring high inflation out of the UK economy by keeping policy tighter for longer, we also see value in positioning for that eventual inversion of the UK Gilt curve (Chart 15). We see the sequencing as being inversion first, and relative Gilt outperformance later, although we do not expect the relative performance of Gilts to worsen with the UK economy set to enter recession before other major economies. Importantly, the forward rates in the Gilt curve are still priced for a somewhat steeper yield curve, making curve flattening trades along the entire curve attractive as positive carry trades that pay you to wait for the eventual policy driven inversion. The 2-year/10-year and 2-year/30-year flatteners look particularly attractive from that carry-focused perspective. Bottom Line: The BoE– under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months, and enter positive carry Gilt curve flatteners now to benefit from the inevitable inversion of the curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Misery Loves Company Misery Loves Company The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Misery Loves Company Misery Loves Company