Business Cycles

Sentiment toward stocks is depressed and European valuations have declined substantially. However, the earnings outlook remains poor. Which side will win?

In this report, we elaborate on why the Chinese central government has been reluctant to open stimulus taps as much as in the past, especially when it comes to the ailing property market. In recent years, there has been a major shift in Beijing’s assessment of the trade-offs between short-term economic growth, sociopolitical stability and the nation's long-term goals. We explain this difficult balancing act, little-known in the global investment community.

The Fed says that to get back to 2 percent inflation, the US unemployment rate must increase by ‘just’ 0.6 percent through 2023-24. All well and good you might think, except that the Fed is forecasting something that has been unachievable for at least 75 years! Is the Fed gaslighting us? And what does it mean for investment strategy?

We remain bearish on equities. Inflation is a monetary phenomenon that is embedded and perpetuated by a wage-price spiral. The Fed will “keep at it until the job is done.” Economic growth is slowing, and an earnings recession as soon as the end of this year is highly likely. US equities are not cheap and rising rates and slowing earnings growth will take their toll on performance. Don’t fight the Fed!

Investors should go long US treasuries and stay overweight defensive versus cyclical sectors, large caps versus small caps, and aerospace/defense stocks. Regionally we favor the US, India, Southeast Asia, and Latin America, while disfavoring China, Taiwan, Hong Kong, eastern Europe, and the Middle East.

Executive Summary For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. To reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. In the US, a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. This reiterates our ‘2022-23 = 1981-82’ template for the markets. A coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. It Now Costs Twice As Much To Buy Than To Rent A UK Home! It Now Costs Twice As Much To Buy Than To Rent A UK Home! It Now Costs Twice As Much To Buy Than To Rent A UK Home! Bottom Line: Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. Feature Mortgage rates around the world have skyrocketed. The UK 5-year fixed mortgage rate which started the year at under 2 percent has more than doubled to over 5 percent. And the US 30-year mortgage rate, which began the year at 3 percent, now stands at an eyewatering 7 percent, its highest level since the US housing bubble burst in 2008. This raises a worrying spectre. Is the recent surge in mortgage rates about to trigger another housing crash? (Chart I-1 and Chart I-2). Chart I-1UK Mortgage Rate Has Doubled UK Mortgage Rate Has Doubled UK Mortgage Rate Has Doubled Chart I-2US Mortgage Rate Has Doubled US Mortgage Rate Has Doubled US Mortgage Rate Has Doubled A good way to answer the question is to compare the cashflow costs of buying versus renting a home. This is because home prices are set by the volume of homebuyers versus home-sellers. If would-be homebuyers decide to rent rather than to buy – because renting gets them ‘more house’ – then it will drag down home prices. Here’s the concern. For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. Put another way, whatever your monthly housing budget, you can now rent a home worth twice as much as you can buy (Chart I-3 and Chart I-4). Chart I-3It Now Costs Twice As Much To Buy Than To Rent A UK Home! It Now Costs Twice As Much To Buy Than To Rent A UK Home! It Now Costs Twice As Much To Buy Than To Rent A UK Home! Chart I-4It Now Costs Twice As Much To Buy Than To Rent A US Home! It Now Costs Twice As Much To Buy Than To Rent A US Home! It Now Costs Twice As Much To Buy Than To Rent A US Home! The Universal Theory Of House Prices Buying and renting a home are not the same thing, so the head-to-head comparison between the mortgage rate and rental yield is a simplification. Buying and renting are similar in that they both provide you with somewhere to live, a roof over your head or, in economic jargon, the consumption service called ‘shelter’. But there are two big differences. First, unlike renting, buying a home also provides you with an investment whose value you expect to increase in the long run. Second, unlike renting, buying a home incurs you the costs of maintaining it and keeping it up-to-date. Studies show that the annual cost averages around 2 percent of the value of the home.1 So, versus renting, buying a home provides you with an expected capital appreciation, but incurs you a ‘depreciation’ cost of around 2 percent a year. Which results in the following equilibrium between buying and renting: Mortgage rate = Rental yield + Expected house price appreciation - 2 But we can simplify this. In the long run, the price of any asset must trend in line with its income stream. Therefore, expected house price appreciation equates to expected rental growth. Also, rents move in lockstep with wages (Chart I-5). Understandably so, because rents must be paid from wages. And wage growth itself just equals consumer price inflation plus productivity growth, which averages around 1 percent (Chart I-6). Pulling all of this together, the equilibrium simplifies to: Chart I-5Rents Track Wages Rents Track Wages Rents Track Wages Chart I-6Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Mortgage rate = Rental yield + Expected consumer price inflation - 1 So, here’s our first conclusion. Assuming central banks achieve their long-term inflation target of 2 percent, the equilibrium becomes: Mortgage rate = Rental yield + 1 Under this assumption, to justify the current UK rental yield of 3 percent, the UK mortgage rate must plunge to 4 percent. But given that the government has just triggered an incipient balance of payments and currency crisis, the mortgage rate is likely to head even higher. In which case the rental yield must rise to at least 4 percent. Meaning either house prices falling 25 percent, or rents rising 33 percent. Meanwhile, to justify the current US rental yield of 3.7 percent, the US mortgage rate must plunge to 4.7 percent. Alternatively, to justify the current mortgage rate of 7 percent, the rental yield must surge to 6 percent. Meaning either house prices crashing 40 percent, or rents surging 60 percent. More likely though, all variables will correct. The equilibrium between buying and renting will be re-established by some combination of lower mortgage rates, lower house prices, and higher rents. The Housing Investment Cycle Is Turning Down The relationship between buying and renting a home raises an obvious counterargument. What if central banks cannot achieve their goal of price stability? In this case, expected inflation in the equilibrium would be considerably higher than 2 percent. This would justify a much higher mortgage rate for a given rental yield. Put differently, it would justify rental yields to stay structurally low (house prices to stay structurally high), even if mortgage rates marched higher. In an inflationary environment, houses would become the perfect foils against inflation. In an inflationary environment, houses would become the perfect foils against inflation because expected rental growth would track inflation – allowing rental yields to stay depressed versus much higher mortgage rates. This is precisely what happened in the 1970s. When the US mortgage rate peaked at 18 percent in 1981, the US rental yield barely got above 6 percent (Chart I-7). Chart I-7In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... If the market fears another such inflationary episode, would it make the housing market a good investment? In the near term, the answer is still no, for two reasons. First, even if rental yields do not track mortgage rates higher point for point, the yields do tend to move in the same direction – especially when mortgage rates surge as they did in the 1970s (Chart I-8). Some of this increase in rental yields might come from higher rents, but some of it might also come from lower house prices. Chart I-8...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together ...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together ...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together Second, based on the US, it is a bad time in the housing investment cycle. Theoretically and empirically, residential fixed investment tracks the number of households in the economy. But there are perpetual cycles of underinvestment and overinvestment – the most spectacular being the overinvestment boom that preceded the 2007-08 housing crisis. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Therefore, contrary to the popular perception, there is not an undersupply of homes, but a marked oversupply relative to the number of households. (Chart I-9). This is important because, as the cycle turns down now – as it did in 1973, 1979, 1990, and 2007 – the preceding overinvestment always weighs down housing valuations (Chart I-10). Chart I-9The US Housing Investment Cycle Has Moved Into Overinvestment The US Housing Investment Cycle Has Moved Into Overinvestment The US Housing Investment Cycle Has Moved Into Overinvestment Chart I-10A Housing Investment Downcycle Always Weighs On Housing Valuations A Housing Investment Downcycle Always Weighs On Housing Valuations A Housing Investment Downcycle Always Weighs On Housing Valuations The Investment Conclusions Let’s sum up. If the market believes that economies will return to price stability, then to reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. If the market believes that economies will not return to price stability, then house prices are still near-term vulnerable to rising mortgage rates – especially in the US, as a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation – even if the markets do not believe it now. This reiterates our ‘2022-23 = 1981-82’ template for the markets, as recently explained in Markets Still Echoing 1981-82, So Here’s What Happens Next. In summary, a coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. Analysing The Pound’s Crash Through A Fractal Lens Finally, the incipient balance of payments and sterling crisis triggered by the UK government’s unfunded tax cuts has collapsed the 65-day fractal structure of the pound (Chart I-11). This would be justified if the Bank of England does not lean against the fiscal laxness with a compensating tighter monetary policy. But if, as we expect, monetary policy adjusts as a short-term counterbalance, then sterling will experience a temporary, but playable, countertrend bounce. Chart I-11The Pound Usually Turns When Its Fractal Structure Has Collapsed The Pound Usually Turns When Its Fractal Structure Has Collapsed The Pound Usually Turns When Its Fractal Structure Has Collapsed On this assumption, a recommended tactical trade, with a maximum holding period of 65 days, is to go long GBP/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Chart 1Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Chart 2Copper's Tactical Rebound Maybe Over Copper's Tactical Rebound Maybe Over Copper's Tactical Rebound Maybe Over Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started Is Fragile German Telecom Outperformance Has Started Is Fragile German Telecom Outperformance Has Started Is Fragile Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 11The Strong Downtrend In The 3 Year T-Bond Is Fragile The Strong Downtrend In The 3 Year T-Bond Is Fragile The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Fragile The Outperformance Of Tobacco Vs. Cannabis Is Fragile The Outperformance Of Tobacco Vs. Cannabis Is Fragile Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The Rate of Return on Everything, 1870–2015 (frbsf.org) Fractal Trading System Fractal Trades Will Surging Mortgage Rates Crash House Prices? Will Surging Mortgage Rates Crash House Prices? Will Surging Mortgage Rates Crash House Prices? Will Surging Mortgage Rates Crash House Prices? 6-12 Month Recommendations 6-12 MONTH RECOMMENDATIONS EXPIRE AFTER 15 MONTHS, IF NOT CLOSED EARLIER. Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted China's Semi Imports Plummeted China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Global Auto Production Will Rise Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang Semiconductor Inventory Overhang Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

Executive Summary What To Do With The Euro? What To Do With The Euro? What To Do With The Euro? The outlook for European assets is uniquely muddled. European energy prices will remain elevated, but the worst of the adjustment is already behind us. The global economy is teetering on the edge of a recession and weak global growth is historically very negative for European assets. However, European valuations and earnings forecasts already discount an extremely severe outcome for global growth. A hawkish Fed should support the dollar, but investors increasingly realize foreign central banks are fighting inflation equally aggressively. The dollar already anticipates a global recession. Meantime, European credit offers a large spread pickup over sovereigns and even appears as a decent alternative to equities. Within a credit portfolio, we adopt a more cautious approach towards European investment grade bonds (IG) relative to their US counterpart. Instead, we recommend favoring UK IG over Euro Area IG as well as Swedish IG relative to US IG.    Recommendations INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT Set a stop buy at EUR/USD 0.9650 with a stop-loss at 0.9400 9/26/2022     Bottom Line: Investors should maintain a modest long position in equities in European portfolios, with a preference for defensive stocks over cyclicals. The conditions are falling in place to buy the euro tentatively.   Following the hawkishness that transpired from the Fed press conference and revised forecasts last week, EUR/USD plunged below 0.99 and hit a 20-year low. Moreover, President Vladimir Putin’s announcement of a broader mobilization of the Russian army is stoking fears that the Ukrainian conflict will only be prolonged. The prospects of a lengthier war and greater energy market shock are raising further worries for Europe’s growth outlook, which weighs on European asset prices, notably the euro and the pound. The odds of a global financial accident are on the rise. Global central banks have joined the Fed and are relentlessly tightening global monetary and financial conditions. Moreover, the surging dollar is adding to global risks by raising the cost of capital around the world. This is a very fragile situation and the odds of a global recession have jumped significantly. Against this backdrop, investors should continue to overweight defensive equities at the expense of cyclical stocks. The euro also has more downside, but we are issuing a tentative stop-buy at EUR/USD 0.9650 with a stop at 0.9400. Credit remains a safer alternative to European stocks. The Evolving European Energy Backdrop Chart 1All About The Gas All About The Gas All About The Gas The surge of natural gas and electricity prices since the fall of 2021 has been one of the main drivers of the underperformance of European assets and the fall in the euro (Chart 1). While the medium-term outlook for European energy prices remains fraught with risk, the near-term prospects have improved. Following a surge from €77.4/MWh in June to €340/MWh on August 26, one-month forward natural gas prices at the Dutch Title Transfer Facility (TTF) have declined 45% to €187/MWh. These wild gyrations reflect the evolution of both the natural gas flows from Russia, which have fallen from 3,060Mcm to 599 Mcm today, and the rapid buildup of natural gas inventories across the European Union. The good news is that the costly efforts to rebuild European gas inventories have been successful. EU-wide inventories are at 85.6% capacity, achieving its 80% storage objective well before November. Germany has gone even further, with storage use now standing at 90% of capacity. This large stockpile, along with the re-opening of coal power plants and consumption curtailment efforts, should allow Europe to survive the winter without Russian energy imports, as long as the temperatures are not abnormally cold. The absence of a summer dip in Norwegian gas exports and the surge in LNG flows to Europe have partially replaced the missing Russian inflows, thus helping Europe rapidly rebuild its natural gas inventories (Chart 2). This success was a consequence of elevated European natural gas prices, which have allowed Europe to absorb LNG flows from the rest of the world (Chart 3). Chart 2No Restocking Without LNG No Restocking Without LNG No Restocking Without LNG Chart 3LNG Flowed Toward High Prices LNG Flowed Toward High Prices LNG Flowed Toward High Prices So far, the European industrial sector has managed to adjust better than expected to the jump in the price of natural gas, a crucial energy input. Take Germany as an example. For the month of August, Germany’s consumption of natural gas by the industrial sector fell 22% below the 2018-2021 average (Chart 4, top panel), while PPI moved up vertically. Yet, industrial output is only down 5% year-on-year and industrial capacity utilization stands at 85%, which is still a level that beats two thirds of the readings recorded between 1990 and this the most recent quarter (Chart 4, bottom panel). The adjustment will be uneven across various industries, with those most voracious of natural gas likely to experience a declining share of Europe’s gross value added. Using the German example once again, we can see that the chemicals, basic metal manufacturing, and paper products sectors are the most at risk from higher natural gas prices and most likely therefore to suffer the most from gas rationing this winter (Chart 5). Chart 4A Surprisingly Successful Transition A Surprisingly Successful Transition A Surprisingly Successful Transition Chart 5The Three Sectors Most At Risk Is Europe About To Be Crushed? Is Europe About To Be Crushed? Going forward, important changes are likely to take place that will allow the European economy to continue to survive on diminished Russian gas flows: European natural gas prices will remain elevated compared to the rest of the world to attract LNG flows to the region. Importantly, Europe’s capacity to absorb these flows keeps increasing, as more re-gasification ships are docked around the continent. Moreover, North America is building more facilities to export LNG to Europe. Chart 6Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear Energy's Contribution Will Rebound Nuclear electricity production will rebound. Currently, the EU’s nuclear production is around 43.2TWh, well below the normal 60TWh to 70TWh winter levels, driven mostly by the collapse in French production from 35TWh to 18TWh (Chart 6). This decline in nuclear electricity generation has accentuated the upward pressure on European natural gas and electricity prices. One of the key objectives of the nationalization of EDF by the French government is to accelerate the maintenance of France’s ageing nuclear power plants and allow a return to more normal production levels by the winter. The role of natural gas in European household’s energy mix will decline. Currently, EU households are the largest natural gas consumers and account for 41% of the bloc’s gas consumption (Chart 7). It will be easier to replace their natural gas consumption over time with other sources of energy than it will be to cut the industrial sector’s consumption extensively. As a result, even if European natural gas imports are permanently below 2021 levels, the industrial sector will not bear the brunt of the adjustment. Chart 7Households To Be Displaced Is Europe About To Be Crushed? Is Europe About To Be Crushed? These developments imply that natural gas prices have limited downside. However, we believe that the worst of the spike in prices is behind us, at least over the near term. The reason is that the inelastic buying created by the inventory re-stocking exercise since May 2022 is ending. In fact, the German Federal Minister for Economic Affairs and Climate Action, Robert Habeck, declared last week that his country would no longer purchase gas at any price. Chart 8The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over The Most Painful Part Of The Adjustment Is Over If prices stabilize around €200/MWh, European industrial activity will continue to face a headwind, but the worst of the adjustment process will be in the rearview mirror as natural gas inflation recedes (Chart 8). Ultimately, capitalist systems are dynamic, and it is this rapid change in price that causes the most pain. In other words, the impoverishment of the European private sector has already happened. Steady states are easier to manage. Moreover, if natural gas prices eventually follow the future’s curve (this is a big “if”), the picture for Europe will improve considerably. One additional mitigating factor should ease the pain being experienced by the European private sector. Fiscal policy is responding very aggressively to the current energy crisis. So far, EU countries and the UK have allocated more than €500 billion to protect their private sectors against higher energy costs (Chart 9) and the UK just announced tax cuts of £45 billion. This is in addition to the disbursement of €150 billion from the NGEU funds in 2023. Moreover, the European commission is planning to modify the EU fiscal rules to abandon annual structural deficit targets and for debt sustainability to be evaluated over a ten-year period. Chart 9Massive Fiscal Support Is Europe About To Be Crushed? Is Europe About To Be Crushed? Bottom Line: The worst of Europe’s adjustment to higher energy prices is now behind us. However, European energy prices will remain elevated, which will continue to put Europe at a handicap compared to the rest of the world. Bad News From The Rest Of The World The worst of Europe’s energy crisis is behind us, but the world is teetering toward a recession, which will hurt the trade- and manufacturing-sensitive European economy. Chart 10A Global Recession This Way Comes A Global Recession This Way Comes A Global Recession This Way Comes The tightening in global financial conditions created by the surge in the dollar and by the jump in global yields is pushing the US Manufacturing ISM and the Euro Area PMIs toward the low-40s, which is consistent with a recession (Chart 10). The problem does not stop there. Global central banks have become solely focused on fighting inflation. For 2023, the FOMC’s dot plot forecasts both an interest rate rise to 4.6% and a 0.7% increase in the unemployment rate. This is tantamount to the Fed telling the market that it will increase interest rates as a recession emerges to repress inflation. Not to be undone, European central banks are also rapidly increasing their policy rates, even as they also forecast an imminent deterioration in domestic growth conditions. Quickly tightening policy in a slowing growth environment, especially as the dollar hits a 20-year high, is a recipe for a financial accident and a global recession. Chart 11No Help From China No Help From China No Help From China Moreover, China’s economy is still unable to create a positive offset to the deterioration in global monetary and financial conditions. The marginal propensity of China’s private sector to consume remains in a downtrend, hampered by the country’s zero-COVID policy and the continuing meltdown in real estate activity (Chart 11). Furthermore, the most rapid decline in the yuan exchange rate in 5 years is imparting an additional downside risk to the global economy. European stocks are uniquely exposed to these threats. Europe overweights deep cyclicals, which are currently squeezed by the deteriorating global growth outlook. The message from the collapse in FedEx’s stocks on very poor guidance is particularly ominous: this company has a much closer correlation with the Dow Jones Euro STOXX 50 than with the S&P 500 (Chart 12). European share prices are already factoring in much of the bad news. Valuations are significantly less expensive than they once were. The Shiller P/E ratio of European equities and their equity risk premium stand at the same levels as those in the 1980s. This is in sharp contrast to the US (Chart 13). Chart 12FedEx's Gloomy Delivery FedEx's Gloomy Delivery FedEx's Gloomy Delivery Chart 13Low CAPE In Europe Low CAPE In Europe Low CAPE In Europe Table 1A Deep Downgrade To European Earnings Is Europe About To Be Crushed? Is Europe About To Be Crushed? European forward earnings have also already done considerable work adjusting downward. Excluding energy, 2022 and 2023 forward EPS are down 10.3% and 11.9% since their peak, respectively (Table 1). But inflation flatters earnings growth and European large-cap indices are dominated by multinational firms, which implies that looking at earnings in USD terms makes more sense. In both real and USD terms, 2022 and 2023 forward EPS, excluding energy, are already down 25% and 26.4%, respectively. These adjustments are in line with previous recessions. The counterargument is that analysts still expect positive earnings growth in 2023 relative to 2022. However, at 4%, this increase in expected earnings is still well below inflation and 6% below the average expected growth in forward earnings recorded over the past 35 years (Chart 14). Additionally, a global recession could put further downward pressure on energy prices in Europe, which would create an additional cushion under European earnings in 2023 The implication here is that it still makes sense to be modestly long European equities in absolute terms, especially for investors with an investment horizon of twelve months or more. However, we cannot be complacent, as the risk of an additional selloff is still too large for comfort. As a result, for now investors should only garner a small exposure to European equities and do so while favoring defensive names over cyclical ones (Chart 15). Chart 14Weak Forward Earnings Growth Weak Forward Earnings Growth Weak Forward Earnings Growth Chart 15Continue To Favor Defensive Names Continue To Favor Defensive Names Continue To Favor Defensive Names Bottom Line: European stocks must still contend with the growing threat of a global recession catalyzed by tighter financial conditions and aggressive global central banks. The good news is that they already discount considerable pessimism, as illustrated by their low valuations and downgraded forward earnings. Consequently, investors can continue to nibble at European equities, but do so to a limited degree and by favoring defensive stocks over cyclical ones, at least for now. The Euro Dilemma On the back of the very hawkish Fed meeting and the announcement of Russia’s broadened military mobilization, the EUR/USD broke below the 0.99 support level and fell under 0.98, a level we judged in the past as very attractive on a six-to-nine months basis. Obviously, Fed Chair Jerome Powell’s reaffirmation of the FOMC’s war on inflation is a major boost to the dollar. The momentum property of the greenback implies that it has room to rally further in the near term. This narrative, however, overlooks the fact that the Fed is not the only central bank intent on fighting inflation, no matter the cost. The Norges Bank, the Riksbank, the ECB, and even the SNB have all showed their willingness to move aggressively against inflation. While the BoE only increased rates by 50bps last week, its communication suggested that an at least 75bps increase would be due at the November meeting, when the MPC publishes its Monetary Policy report that will incorporate the impact of the budget measures announced by new British Prime Minister, Liz Truss. Chart 16The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed The Rest Of The World Is Catching Up To The Fed As a result, market interest rate expectations are climbing in the US, but they are rising even faster in Europe, albeit from a lower base. However, the decline in the expected rate of interest in the US relative to Europe and in the number of expected hikes in the US relative to Europe are consistent with a sharp decline in the DXY in the coming months (Chart 16). Due to its 80% weight in European currencies, a weaker DXY implies a rebound in the EUR, GBP, CHF, NOK, and SEK against the USD. Chart 17Surprising European Resilience Surprising European Resilience Surprising European Resilience Moreover, there could be room for expected interest rate differentials to narrow further against the dollar. The analysis we published two weeks ago shows that, even when the different nonfinancial private debt loads are accounted for, the gap in the US and Eurozone r-star stands at 1%. However, the spread between the Fed funds rate’s upper bound and the ECB Deposit Rate is 2%. The gap between the July 2023 US and Eurozone OIS is 1.7%. Since European inflation may prove more stubborn than that of the US in the near term, there is scope for the expected interest rate gap to narrow further, especially as the Euro Area final domestic demand is surprisingly more robust than that of the US (Chart 17). What about global growth? The view that the global economy is about to experience a recession is consistent with a stronger dollar, since the greenback is an extremely countercyclical currency. However, the DXY’s 25% rally since January 2021 already prices in such an outcome (Chart 18). Similarly, the euro is trading again at 2002 levels, which is also in line with a global recession with deep negative repercussions for the Eurozone. Additionally, the Euro has fallen 21% since May 2021, which compares to the 21.4% fall in 2008, the 20% decline in 2010, the 18% plunge in 2011/12 and the 24% collapse in 2014/15; yet EUR/USD is much cheaper now than in any of those instances. Moreover, the wide difference between the competitiveness of Germany and that of the rest of the Euro Area has now faded, which means that a major handicap against the euro has disappeared (Chart 19). Chart 18The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession The Dollar Already Foresees A Recession Chart 19Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness Normalizing Eurozone Internal Competitiveness This does not mean that the euro is not without risk. First, since the major euro collapse began in June 2021, EUR/USD breakdowns have been followed by average declines of 3.6%, ranging from 2.7% to 4.2%. Since the dollar is a momentum currency, it is unlikely that this time will be different. Second, if the tightening in global policy does cause a financial accident, the dollar will catch one last major bid that could push EUR/USD toward 0.9. As a result, to mitigate the danger, we recommend setting a stop-buy in the euro at EUR/USD 0.965 or 2.6% below the breakdown level of 0.9904. This position comes with a stop-loss at 0.94. For now, we would view this bet as a tactical position if it were triggered. Bottom Line: While a hawkish FOMC is very positive for the dollar, markets now expect foreign central banks to catch up to some extent with the Fed. This process is dollar bearish. Additionally, while a global recession would be supportive of the greenback, the USD already discounts this scenario. Instead, Europe is proving surprisingly resilient, which could soon create a tailwind for EUR/USD. Set a stop-buy at EUR/USD 0.965, with a stop-loss at 0.94. Market Update: European Credit After Central Bank Week For investors concerned with the left-tail risk in European equities, European credit offers a credible alternative in the near term. This asset class is also attractive relative to European government bonds. Taken together, the Fed, the ECB, the BoE, the Riksbank, the Norges Bank, the SNB, and the BoC have tightened policy by 475bps over the past month (Chart 20). Moreover, the SNB’s hike closed the chapter of negative rates in Europe. But make no mistake – there will be a second chapter. Until then, European corporate bond yields have risen enough to offer attractive spreads over duration-matched government bonds and to challenge the earnings yield provided by equities (Chart 21). Besides, the volatility observed in equity markets over the past few months makes the European corporate bond more appealing. Chart 20Central Bank Week Is Europe About To Be Crushed? Is Europe About To Be Crushed? Chart 21Push Back Against TINA Argument Push Back Against TINA Argument Push Back Against TINA Argument In the Euro Area, BB-rated bonds, which are the highest credit quality and largest tranche within the high-yield space, are particularly attractive. They sport a 6.6% YTM, at a spread of 480bps over 3-year German government bond yields. This compares to an equity earnings yield of 7.4% (Chart 21, top panel). In other European corporate bond markets, there is no need to go down in credit quality. Yields-to-maturity for investment grade corporate bonds in the UK, Sweden, and Switzerland provide appealing alternatives to equities, with shorter duration still. This is especially true in Sweden, where the equity earnings yield has collapsed and is now only 60bps above Swedish IG yield, with substantially greater risk. Meanwhile, the spread pickup offered by Swiss IG over Swiss government bonds of similar duration is at its widest in more than ten years (Chart 21, bottom panel). Chart 22Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials Heed The Message From OIS Curve Differentials This week, we turn neutral on European credit versus US credit. Back in March, we made the case that European credit would outperform its US counterpart in response to a more hawkish Fed than the ECB. Since then, European IG outperformed US IG by 1% on a total return basis. However, with the Fed funds rate at 3.25%, traders now expect more monetary policy tightening from the ECB, which often corresponds to an underperformance of Euro Area credit relative to that of the US (Chart 22, top panel). On the other hand, Swedish IG is expected to outperform US IG over the next six months (Chart 22, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Chart 1Turkey's Export Competitiveness Turkey's Export Competitiveness Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​ Chart 3Turkish Energy Ties With Russia Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling Real Incomes Falling Real Incomes Falling ​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election ​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election ​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits ​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc ​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation ​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations ​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP ​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Figure 2The Net Forces On A Brick Pulled By An Elastic Band Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph.  Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph!  The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent 2008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable Inflation’s ‘Non-Linearity’ Makes It Uncontrollable 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations