Currencies
Executive Summary Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth The conditions for a major rally/outperformance in Malaysian equities are absent. Profits have been the primary driver of Malaysian equity prices historically, and the corporate earnings outlook is mediocre. Domestic demand is facing headwinds from tightening fiscal policy as well as from impaired credit channels. Muted wage growth and deflating house prices are sapping consumer confidence. This will dent domestic demand going forward. This backdrop is bullish for bonds. Malaysian bonds offer value, as real bond yields are among the highest in Emerging Asia. The yield curve is far too steep given the growth and inflation outlook. The Malaysian ringgit is cheap and has limited downside. Bottom Line: We recommend equity investors implement a neutral stance toward Malaysia in overall EM and Emerging Asian equity portfolios. Absolute return investors should avoid this bourse for now. Fixed-income investors, on the other hand, should stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. In the rate markets, investors should continue receiving 10-year swap rates or bet on yield curve flattening. Feature Chart 1Malaysian Equity Underperformance May Be Late, But It’s Not Yet Time To Overweight Malaysian stocks are still in search of a stable bottom in absolute terms. Relative to their EM and Emerging Asian counterparts however, a bottom has been forming over the past year (Chart 1). So, could Malaysia’s prolonged underperformance be coming to an end? Our analysis suggests caution. The underlying reasons behind this market’s substantial and protracted underperformance – dwindling earnings both in absolute terms and relative to its peers – are yet to show any signs of a reversal. While cheap, the ringgit is also negatively impacted by the meager corporate profits generated by Malaysian firms. Investors would do well to stay neutral on this bourse for now in EM and Emerging Asian equity portfolios. Fixed income investors, however, should continue to stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. Also, Malaysia’s yield curve is too steep and offers value given the sluggish cyclical growth outlook. It’s All About Profits Chart 2 shows that the bull and bear markets in Malaysian stocks have been all about the rise and fall in earnings per share (EPS). Stock multiples, the other possible driver of the equity prices, have been remarkably flat over the past two decades, with only brief periods of fluctuations around the GFC and COVID-19 pandemic. The same can be said about Malaysia’s relative performance vis-à-vis EM and Emerging Asian stocks. The trajectory of the relative stock performance was set by the relative earnings (Chart 3). Chart 3Malaysia’s Relative Performance Is Also Dictated By Relative Corporate Profits Chart 2Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Thus, it is reasonable to expect that for this bourse to usher in a new bull market in absolute terms, Malaysian firms need to grow their earnings sustainably. And in order to outperform the rest of the EM stocks, Malaysian earnings need to grow at a faster clip than their peers. The question therefore is, are there signs of profit recovery in Malaysian companies in absolute and relative terms? The short answer is no. Bottom-up analysts do not expect any change in the downward trend in Malaysia’s relative profits over the coming 12 months. This outlook is corroborated by our macro analysis, as is outlined below. Sluggish Growth Malaysian profits are languishing in large part because of subdued topline growth. While profit margins are returning to pre-pandemic levels – thanks to cost cutting – subdued sales are causing the corporate profits to stay low. Chart 4Malaysian Domestic Demand Is Subdued Malaysian gross output as of Q4 last year was barely at pre-pandemic levels. The weak recovery is most evident in the dismal level of capital investments. Gross fixed capital formations – in both real and nominal terms – are still a good 15% below their pre-pandemic levels (Chart 4, top two panels). Apathy among businesses in ramping up productive capacity indicates a lack of confidence in consumer demand going forward. Consumption is indeed weak: Unit sales for passenger vehicles continue to be sluggish, and commercial vehicle sales are not faring any better. Consumer sentiment has ticked down in the latest survey indicating retail sales might decelerate (Chart 4, bottom two panels) Consistently, industrial production in consumer goods-related industries is struggling to surpass previous highs, even though strong export demand has provided a fillip to sales. In more domestic-oriented industries such as construction goods, the weakness is palpable (Chart 5). Meanwhile, unemployment rates have fallen marginally, but are still higher than they were before the pandemic. As a result, wages remain subdued. The resulting weak household income is contributing to depressed consumption. With mediocre household income growth, demand for houses has also slowed meaningfully. This is reflected in dwindling property unit sales. The advent of the pandemic and the resulting loss of household income have further aggravated the situation. In fact, prices of certain types of dwelling units, such as semi-detached houses and high-rise apartments, are deflating outright (Chart 6, top panel). Falling house prices weigh on consumer sentiment and discourage future consumption. Chart 6Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Chart 5Weak Domestic Demand Is A Headwind To Industrial Production What’s more, the housing sector does not expect an early recovery in sales and prices either. This is evident in the very depressed level of new construction starts (Chart 6, bottom panel). As such, this sector is likely to remain a drag on Malaysia’s post-pandemic recovery. Fiscal And Credit Headwinds Going forward, the recovery will face other headwinds worth noting. One of them is a restrictive fiscal policy. This is because the “statutory debt” ceiling of the government – at 60% of GDP – has already been reached (Chart 7, top panel). This ceiling for statutory debts was fixed by lawmakers as part of a stimulus bill (COVID-19 Act) passed in 2020; and leaves little room for additional fiscal stimulus. Indeed, the IMF estimates that the ‘fiscal thrust’ this year will be negative at 2% of GDP (Chart 7, bottom panel). The country’s credit channel is also compromised. The reason is that Malaysian banks are still saddled with unresolved NPLs. These NPLs are a legacy of a very rapid expansion of bank loans following the GFC. In just five years (2009 -2014), bank credit doubled in nominal terms to 1500 billion ringgit or from 95% of GDP to 125% (Chart 8, top panel). Such fast deployment of credit was bound to cause significant misallocation of capital. And yet banks were averse to recognize impaired loans in any good measure. In fact, during the years of rapid credit growth, banks were recognizing ever fewer amounts in absolute terms as impaired loans. They were also setting aside ever lower amounts as loan loss provisions (Chart 8, second panel). Chart 7Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Chart 8Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised While bad debt recognition and provisions have risen modestly over the past year, Malaysia’s reported NPL ratio remained under 1.5% of loans (Chart 8, third panel). Loan loss provisions have been equally meager. This indicates that banks’ balance sheets are far from clean. In reality, Malaysian borrowers never went through any deleveraging process following their last credit binge. The bank credit-to-GDP ratio remains at around the same level as it was in 2015 (125% of GDP). By comparison, during Malaysia’s previous deleveraging phase, bank credit was shed from 150% of GDP to 90% (1998 - 2008). Borrowers already saddled with large amounts of debt are much less likely to borrow more to invest and/or consume. This is therefore going to cap credit demand. Chart 9Banks Are Piling Up On Government Securities By Shunning Loans As for banks, an increase in impaired loans makes them reticent to engage in further lending. Instead, they seek to accumulate safer assets such as government bonds. In fact, this is what Malaysian banks have been doing. They have ramped up their holdings of government securities materially since 2015 at the expense of loans and advances (Chart 9, top panel). After the pandemic-related slowdown in the economy, banks’ loan books are now probably more encumbered with impaired loans. As such, banks are even less likely to ramp up their loan books in any major way. That will be yet another headwind to economic recovery (Chart 9, bottom panel). Value In Fixed Income The headwinds to growth do not entail a bullish outlook for Malaysian equities. The outlook for Malaysian local currency bonds, however, is promising. A tightening fiscal policy amid weak domestic demand and subdued inflation is a bullish cocktail for domestic bonds. There is a good chance that Malaysian bond yields will roll over. At a minimum, they will rise less than most other EM countries or US Treasuries. Notably, Malaysia offers one of the highest real yields (nominal yield adjusted for core inflation) in Emerging Asia (Chart 10, top panel). Given the country’s mediocre growth outlook, odds are high that Malaysian local bonds will outperform their EM / Emerging Asian peers (Chart 10, bottom panel). Chart 10Malaysian Bonds Offer One Of The Best Values In Emerging Aisa Chart 11Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks The Malaysian swap curve is also far too steep given the country’s macro backdrop. Going forward, the 10-year/1-year swap curve is set to flatten from its decade-steep level of 130 basis points (Chart 11, top panel). That means investors should continue receiving 10-year swap rates. On a related note, a fall in bond yields will not augur well for Malaysian stocks in general, and bank stocks in particular. The middle panel of Chart 11 shows that bank stocks struggle in absolute terms whenever bond yields decline. Incidentally, at 38% of total, banks are by far the largest sector in the MSCI Malaysia Index. And in recent months bank stocks have been propelling the Malaysian market (Chart 11, bottom panel). Should the bourse begin to miss the tailwind from rising bond yields, Malaysian equity performance will be hobbled. Finally, investors should stay overweight in Malaysian sovereign credit. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, periods of global risk-off witness Malaysian sovereign spreads fall relative to their EM counterparts, as they did in 2015 and again in 2020. In the months ahead, rising US inflation and a slowdown in Chinese property markets could cause another such period. That will lead Malaysian sovereign US dollar bonds to continue outperforming their EM peers. What’s With The Ringgit? Chart 12Malaysia Has Not Been Able To Benefit From A Cheap Currency The Malaysian currency is cheap, both in nominal and real terms (Chart 12, top panel). As such, it will likely be one of the most resilient currencies in EM this year. That said, the ringgit has been cheap for a while now (since 2015), and yet the Malaysian economy does not seem to have benefitted much all these years. The inability to take advantage of a cheap currency points to a fundamental malaise in the Malaysian economy: Loss of manufacturing competitiveness, as explained in our previous report on Malaysia. Perhaps equally worryingly, the country has not been able to attract much in the way of capital inflows. What this implies is that global investors did not find Malaysian assets attractive enough despite the benefits of a significantly cheaper currency (Chart 12, bottom panel). A major reason investors have not found the country attractive is because the return on capital on Malaysian assets has continued to deteriorate relative to the rest of the world. The upshot of the above is that, should Malaysian firms be able to improve their profits going forward, Malaysian stocks’ relative performance would get a boost from both higher relative earnings and a stronger currency. However, given the sluggish business cycle outlook as explained above, a sustainable rally in Malaysian stocks or currency is not imminent. Investment Conclusions Chart 13Malaysian Relative Stock Valuations Are On The Cheaper Side Equities: Malaysian stocks have cheapened. Both in terms of P/E ratio and P/book ratio, they are at the lower end of the spectrum relative to their EM counterparts (Chart 13). Yet, given the mediocre growth outlook, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines in view of the worsening risk outlook in global markets, and wait for a better entry point later in the year. For local asset allocators in Malaysia, it is too early to overweight stocks relative to bonds over a cyclical horizon. Even though the equity risk premium in general has been much higher since the advent of the pandemic, stocks have struggled to outperform bonds in a total return basis over the past two years. That will likely be the case for several more months given the country’s growth outlook and rising global risks. Fixed Income: Malaysian domestic bonds will outperform their overall EM / Emerging Asian peers. So will Malaysian sovereign credit. Fixed income investors should overweight them in their respective EM / Emerging Asian portfolios. In the rate markets, investors should continue receiving 10-year swap rates. Finally, Malaysian yield curves are set to flatten. Investors should position for a narrowing of the 10-year/1-year yield curve, which is at a decade-high level of 180 basis points. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com
Canada’s CPI inflation rate increased in January, reinforcing the case for the Bank of Canada to start hiking interest rates at its March 2 meeting. Headline CPI inflation rose to 5.1% y/y from 4.8%, while the three core inflation measures all accelerated and…
Executive Summary The Euro And Relative Growth The euro is likely to appreciate over the course of 2022. But the path will be volatile, with a retest of recent EUR/USD lows within the central band of possible outcomes. Our 2022 target for the euro is 1.20. This partly hinges on cheap valuations. Beyond 2022, a bold estimate could see the euro gravitate towards 1.40. The pricing of interest rate hikes by the ECB this year are too aggressive. But this is also the case for the Federal Reserve, especially if inflation proves transitory. Our bias is that appreciation in the euro will be more driven by improving relative economic fundamentals as the 2022 cycle unfolds. A bottom in Chinese growth could be the ultimate arbiter of which mega economy outperforms. Sentiment on the euro is only neutral. This suggests that an escalation in Russo-Ukrainian tensions, as well as a more dovish ECB, are key risks in the short term. A short EUR/JPY position is a good hedge for this risk. In our FX portfolio, we are long EUR/CHF and long EUR/GBP as equally playable themes. We would buy the EUR/USD at current levels but suspect a better entry point awaits us. Recommendations Inception Level Inception Date Return Long EUR/CHF 1.05 2021-11-19 0.62% Long EUR/GBP 0.846 2021-10-15 -.71% Bottom Line: A positive surprise in Chinese growth, which will boost the euro area trade balance, will be a catalyst for eurozone growth. So will a decline in Russo-Ukrainian tensions and lower energy inflation. Feature The most persistent question we have received in recent weeks is the outlook for the euro. As the premier anti-dollar asset, most clients have been surprised by recent strength in the European currency, betting that a hawkish Fed and US exceptionalism will push the greenback to new highs. A domestic energy crisis interlinked with a brewing war in their backyard has created perfect conditions for selling the euro. With US inflation surprising to the upside, the case for maintaining a dollar-bullish stance remains in place. Yet, the dollar is well below its previous highs. Our suspicion is that the market faces a conundrum. Transitory inflation will nudge the Fed to underwhelm market expectations of aggressive rate hikes. Meanwhile, sticky inflation means that other central banks will eventually catch up to the Federal Reserve in tightening monetary policy. This tug of war has been a defining theme of our strategy for currencies in 2022.1 Specific to the euro area, there is a lot of bad economic news that is now well priced in, while good news is underappreciated by markets. This is becoming evident in the interest rate market, where real Bund yields are creeping noticeably higher. The spread of Omicron in the euro area is receding in lockstep with the deceleration in the US (Chart 1). As a result, the potential growth profile of the euro area is improving tremendously (Chart 2). Should this prove durable, it will put a solid floor under the euro. Chart 1The Pandemic Is Receding Chart 2The Euro And Relative Growth The Case For European Growth Growth is moderating around the world. That said, the German manufacturing PMI has been sharply outpacing that of the US. What is also true is that most measures of euro area growth that we monitor are rising fast relative to the US. The results are preliminary, but the possibility of a growth rotation from the US to other economies, including the eurozone, is very much underappreciated by markets. The economic surprise index in the euro area is strong relative to the US, pointing to a stronger euro (Chart 3). Bloomberg economic forecasts suggest that euro area growth will outpace growth in the US this year. According to the consensus, the euro area will grow by 4.2% in 2022, compared to the US at 3.9%. Remarkably, eurozone growth has typically lagged growth in the US by a significant margin. If past is prologue, it suggests the euro is not priced for this paradigm change (Chart 4). Chart 3Economic Surprises And ##br##The Euro Chart 4Bloomberg Forecasters Expect A Pickup In Eurozone Growth Other economic forecasts corroborate this view. The IMF expects eurozone growth to moderate from 5.2%, to 3.9% in 2022. This is an advantage over the US, where growth is expected to moderate from 5.6% in 2021, to 4% in 2022. The Atlanta Fed GDP growth tracker suggests US growth will slow to a crawl in Q1. The ZEW survey points to a meaningful rebound in the German (and euro area) PMI in the coming months (Chart 5). This will further widen the gap between European and US growth. The key denominator for all these forecasts is a bottoming in Chinese growth. The euro area needs the manufacturing and external sector to keep humming, with China as a critical import partner. Industrial production in the euro area, relative to the US, tends to track the Chinese credit impulse closely (Chart 6). Our bias is that the Chinese credit impulse has bottomed. This will be a catalyst for more Chinese demand for European goods. Chart 5The ZEW Survey Points To An Improving German PMI Chart 6Europe Is Partly Dependent On China The ECB And Interest Rates Chart 7The Gap Between Expected US-EUR Interest Rates Is Wide The markets have begun to reprice higher interest rates in the eurozone. Admittedly, this has been partly due to higher expected inflation. In our view, the repricing by markets is warranted due to the gaping wedge between US versus European interest rate expectations. According to December 2022 contracts, markets expect the Fed to hike interest rates by significantly more than the ECB (Chart 7). It is true that structurally, inflation in the eurozone has been lower than in the US. In fact, our European Investment Strategy colleagues highlight that by stripping out energy, and the impact of VAT tax increases, European inflation is even lower. When CPI baskets are adjusted item for item, eurozone inflation today is indeed lower compared to the US, but not by much (Chart 8). For example, energy and transportation are only 14% of the eurozone CPI basket versus 26% in the US (Table 1). Meanwhile, the ECB targets HICP inflation (not core) that sits at 5.1%, versus a target of 2%. Chart 8Item-For-Item Inflation: US Versus Eurozone Table 1Differences In The US And Eurozone CPI Basket In the coming months, inflation is likely to subside in the eurozone, but probably by less than markets expect. The key driver of inflation expectations in the eurozone (and in the US) are long-dated commodity prices (Chart 9). This has become even more evident, given the surge in electricity prices across many European countries. Robert Ryan, our Chief Commodity Strategist, expects long-dated crude prices to be revised upward, as the oil curve remains persistently backwardated. This puts a floor on how low inflation expectations can relapse in the euro area and will keep the ECB on edge. Meanwhile, the employment picture in the eurozone is also improving. Adjusting for the higher rate of structural unemployment, euro area joblessness compares favorably with the US (Chart 10). It is true that wage growth remains anemic, but it is also the case that the behavior of wages can exhibit a structural shift at very low levels of employment. Chart 9What Drives Eurozone Inflation Expectations? Chart 10US Versus Eurozone Labor Markets Finally, the euro zone has a lot of pent-up demand. This could help bolster growth in the coming quarters and even beyond. While not a subject of this report, we suspect that the cascading crises in the eurozone could have sown the seeds for a productivity boom in the coming years. For a 12-18-month outlook, high savings and easy fiscal policy will allow European growth to recover in the coming quarters. EUR/USD Valuation And Future Returns Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 4%-5% a year over the next decade, should the euro stay at current levels of undervaluation versus the US. This will occur if Eurozone inflation keeps lagging that in the US. (Chart 11). That said, this is the Goldilocks case. A simple return to PPP fair value will suggest the euro will rise by a robust 20%. For 2022, our forecast for the euro is more in the 1.20-1.23 range, 8% above current levels. Our stance is measured because investors are only neutral the euro (Chart 12). Usually, this means that the macroeconomic environment becomes the dominant driver, rather than sentiment. With a Russo-Ukrainian crisis still in the backyard and the potential for more market volatility, an undershoot in the euro cannot be ruled out. Chart 11The Goldilocks Case For The Euro Chart 12Sentiment On The Euro Is Only Neutral That said, interest rate differentials are now moving in favor of the euro. Italian BTPs now yield 1.9%, like US Treasurys. The US Treasury-Bund spread has also narrowed. This removes a lot of the incentive for Europeans to flood the US Treasury or TIPs market, should market volatility subside. Given this confluence of factors, we have chosen to play euro strength via two channels: Long EUR/CHF: This trade will benefit from positive interest rate differentials. Also, the Swiss franc has been bid up relative to the euro on safe-haven demand. This has outpaced the traditional demand for safety, using the DXY index as a proxy (Chart 13). Long EUR/GBP: This is a bet on improving economic fundamentals between the eurozone and the UK (Chart 14), as well as a bet on policy convergence between the two economies. Chart 13Stay Long EUR/CHF Chart 14Stay Long EUR/GBP Footnotes 1 Please see Foreign Exchange Strategy Report, “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant”, dated January 14, 2022. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary The European Central Bank (ECB) has engaged in a decisive pivot toward higher policy rates. Markets are pricing in a first interest-rate hike in July and three more increases thereafter in 2022. This is too much for one year. Limited domestic inflationary pressures, weakness in long-term inflation expectations, economic slack, and vulnerability in the periphery will limit the ECB to one hike in December. Nonetheless, the ECB will increase interest rates more than the market anticipates beyond 2022. The UK is setting up for a dangerous latter half of 2022. Too Much Now, Not Enough Later Bottom Line: Bet on a steepening of the euro short-term rate (€STR) curve. Current pricing for 2022 is too aggressive; however, it is too timid beyond the yearend. European financials will be the prime beneficiary of this tilt. Feature On Thursday, February 3, ECB President Christine Lagarde announced a decidedly hawkish pivot at the ECB press conference. The Frankfurt-based institution, worried by higher-than-anticipated inflation, no longer excludes rate hikes for 2022. In a context in which the BoE is resolutely hiking rates and the Fed is ready to initiate a sustained tightening campaign, investors are pricing in a 10bp ECB rate hike as early as July 2022. They also foresee three additional increases by the end of the year. We agree that the ECB will start lifting the deposit rate this year; however, we expect the tightening to begin in December. Nonetheless, we expect the ECB to lift policy rates more aggressively than the €STR prices in subsequent years. European Inflation Is Different Chart 1Surprise! The knee-jerk reaction of investors to price in a sudden, sustained campaign of ECB rate hikes this year similar to that of the Fed is natural in light of elevated Eurozone inflation and inflation surprises (Chart 1). However, we continue to view European inflation as distinct from US inflation. European inflation remains dominated by dynamics in the energy market. While headline inflation increased from 5% to 5.1% in January, the core Consumer Price Index (CPI) declined modestly to 2.3% from 2.6%. Crucially, the variance of headline CPI is still almost fully explained by the variance of its energy component (Chart 2, top panel). However, it is concerning that there is also evident pass-through from energy prices to core CPI taking place today (Chart 2, bottom panel). Naturally, natural gas prices play a particularly important role in this energy-driven inflation spike (Chart 3). Chart 2Energy Still Drives Inflation Chart 3Natural Gas Remains Key Imported inflation is another key driver of European inflation. Chart 4 highlights that there is a robust relationship between the level of headline Harmonized Index of Consumer Prices (HICP) across EU nations and their import prices. This confirms that a large proportion of the European inflationary outburst has taken root outside of the continent’s borders. Chart 4Imported Inflation? Despite this energy-driven, imported inflation, domestic pressures are still much more muted than those in the US. VAT increases played an important role in pushing core CPI higher. Without this contribution, CPI excluding food and energy would be 50 bps lower (Chart 5). Meanwhile, rent inflation remains a modest 1.1%, which is significantly lower than that in the US (Chart 6, top panel), whereas used car CPI is not nearly as extreme as across the Atlantic (Chart 6, bottom panel). Chart 5Elevated Contribution From Taxes Chart 6Comparatively Muted Domestic Inflation Drivers Wage dynamics too are not yet as concerning in the Eurozone as they are in the US. Negotiated wages remain near a record low of 1.4%, and unit labor costs at 0.9% are still inconsistent with strong underlying inflationary pressures (Chart 7, top and second panel). The labor market is tightening and the Euro Area unemployment rate fell to a new low at 7%. However, the total hours worked have not yet reached their pre-pandemic levels (Chart 7, third panel), which suggests that it could take a few more months before the dislocation caused by the pandemic has been fully absorbed and wages become a risk. That being said, it is only a matter of time, as job vacancies are skyrocketing (Chart 7, bottom panel). Chart 8Plentiful Slack Chart 7The Labor Market Will Heat Up... Later The European output gap also limits a repetition of the wage-price spiral taking hold in the US. The OECD’s Weekly Tracker of GDP, a proxy for the overall Eurozone comprised of Germany, France, Italy, and Spain, reveals that, as of mid-January, aggregate output was still 4.9% below its pre-pandemic trend (Chart 8, top panel). Looking at the actual GDP of European countries individually, only France stands above its pre-pandemic trend, whereas Germany, Italy, and Spain still linger well below the average economic path that prevailed from 2012 to 2019 (Chart 8, bottom panels). Chart 9The Inflationary Role Of Bottlenecks Bottlenecks have also played an important role in relation to higher inflation. Goods inflation is much more elevated than services inflation (Chart 9, top panel), and industrial companies rank the ability to procure equipment and materials as their most important production constraint (Chart 9, second panel). However, production bottlenecks are dissipating. A recent Ifo survey highlights that the proportion of retailers with procurement issues declined from 82% in December 2021 to 57% in January 2022. Moreover, the supplier deliveries indexes of the PMIs are improving across the world. In fact, our simple Supply Disruption Index has begun to rollover, which points toward an imminent end to the wave of inflation surprises (Chart 9, bottom panel). European inflation expectations bear the imprint of those more modest domestic inflationary pressures, which explains the comparatively more limited wage-price spiral on the continent. The inflation expectations of Eurozone households are rising, but they are still within the norm of the past 20 years. In the US, they are breaking out. Moreover, our Index of Common Inflation Expectations, designed to mimic the New York Fed’s measure, remains well contained and is tentatively rolling over (Chart 10). Collectively, these forces explain the radically different inflation profiles of the Euro Area and the US. On the western shore of the Atlantic, the two-year annualized rate of change of the core CPI has completely shattered its highs of the past 20 years, indicating that more than simple base-effects are contributing to inflation (Chart 11, top panel). Meanwhile, the two-year annualized rate of change of the European core CPI is higher than the past deflationary eight years, but it is still low compared to the rates that prevailed prior to the European sovereign debt crisis (Chart 11, bottom panel). Chart 10Inflation Expectations: Unlike The US Chart 11Realized Inflation: Unlike The US Chart 12The Coming CPI Peak? Going forward, there remains a high likelihood that Eurozone inflation will soon peak. The impact of the German VAT increases will soon dissipate from the data, energy inflation will diminish as the annual rate of change of oil and natural gas prices peaks, and the growth in monetary aggregates has normalized sharply. Most importantly, in the absence of significant domestic inflationary pressures, the sharp decline in the ZEW Inflation Expectations components point toward a deceleration in headline HICP (Chart 12). Nonetheless, we cannot be too sanguine. The European output gap is likely to close this year and wages pressures will emerge before the end of 2022. As a result, inflation will not fall below 2% anytime soon. Moreover, as we wrote last week, any long-lasting crisis in Ukraine will prevent energy inflation from declining, and thus, there remains significant upside risk to our inflation view in the coming months. Bottom Line: European inflation remains dominated by energy prices and imported price pressures. For now, domestic inflation dynamics are still mild, which explains why Europe’s inflation profile is much shallower than that of the US. Moreover, the near-term picture suggests that the imported inflation will peak, giving a respite to the HICP. Nonetheless, toward the yearend, domestic inflationary forces will pick up as wages gain traction. ECB Pricing: Too Much And Too Little ECB President Christine Lagarde delivered a message that was loud and clear: The ECB is abandoning its ultra-dovish stance. Despite this policy pivot, investors are pricing in too many hikes this year, whereas we only expect one rate increase toward yearend. True, if energy prices spike anew, risks to this forecast will be skewed to the upside. Nonetheless, we are inclined to fade the number of rate hikes priced in for 2022 and bet for more hikes in 2023 and 2024 (Chart 13). Chart 13Too Much Now, Not Enough Later Why does our base case only include one rate hike in December? First, we are considering the entirety of the inflation picture. As we argued above, inflationary dynamics in Europe are much tamer than those in the US, especially in terms of domestic inflation, which the ECB can influence. Moreover, the ECB is still reeling from its infamous 2011 policy mistake, which accentuated underlying deflationary pressures and caused the ECB to undershoot its mandate for eight years in a row (Chart 14). Inflation expectations also offer some leeway to the ECB. Predictions by professional forecasters continue to track below two percent for the medium term. Importantly, market-based inflation expectations remain consistent with a temporary inflation shock, and do not meet yet the ECB’s criteria of being above the 2% target durably. 10-year CPI swaps hover around 2%, driven by the jump in 2-year CPI swaps to 2.7%. Long-dated expectations approximated by the 5-year/5-year forward CPI swap remain below 2% and the inflation curve is its most inverted on record (Chart 15). Chart 15Inflation Swaps Don't Fit The ECB's Criteria Chart 14The Legacy Of The 2011 Mistake In the end, President Lagarde did mention in the press conference that inflation is finally moving toward its target after years of undershoot. In the context described above, it is likely that the ECB will continue to tolerate some higher inflation in the near term if it represses the deflationary mentality that had engulfed the Eurozone last decade and caused a progressive Japanification of the region. This is a small price to pay to exit at last the lower bound of interest rates on a durable basis. Second comes the sequencing of policy. President Lagarde reiterated the importance of the order of events. First, the ECB will have to bring asset purchases to a net zero before lifting rates. It has yet to curtail purchases. The March meeting will be of paramount importance, since it will feature the tapering schedule of the central bank. We continue to see a progressive pace of declining assets purchases that will likely end in September 2022. Moreover, the ECB will want to see how the European economy and markets will absorb the TLTRO cliff this June, when EUR1.3 trillion of facility expire. Chart 16The Italian Constraint Third, the ECB remains hamstrung by financial dynamics in the periphery. On Thursday, as Bund yields rose 10 basis points, BTP yields rose 21 basis points, bringing the Italian-German spread to 150bps, its highest level since September 2020 (Chart 16). Simply put, the periphery remains fragile because Italy and Spain sport some of the most negative output gaps in the region. Waiting for a stronger position out of those countries would let the ECB increase rates further down the road, allowing for a cleaner exit from negative policy rates in Europe. While these factors continue to favor a cautious posture by the ECB in 2022 and, therefore, support our base view of only one 10bps hike in December to be flagged when net purchases end in September, they will evolve and allow for many more hikes in 2023 and 2024. We expect the following developments to unfold: The output gaps across the region will close this year, which will put the economy in a position of strength and generate stronger domestic inflationary pressures down the road. Salaries will begin to accelerate meaningfully by the summer. This force will accentuate domestic inflationary pressures in late 2022 and 2023, and will contribute to higher household inflation expectations. The periphery will grow increasingly stronger as the Next Generation EU (NGEU) disbursements accelerate in 2022 and 2023. These disbursements are primarily geared toward infrastructure/capex spending (Chart 17) and will therefore sport elevated fiscal multipliers. The resulting strength will provide more resilience to the periphery and limit the tightening of financial conditions caused by higher interest rates. Chart 17The NGEU Will Matter… A Lot Chart 18Terminal Rates Are Too Low In the longer term, we also believe that markets still understate the ability of the ECB to lift rates. The market-derived terminal rate proxy for Europe is in the vicinity of the levels recorded in the wake of the European sovereign debt crisis last decade (Chart 18). Fiscal policy is more generous, however, and thus domestic demand is stronger. As a corollary, the accelerator model implies that capex will be more robust than it was last decade. Finally, the European Union is not as politically divided as it once was, which creates a stronger block. Together, these developments suggest that the r-star or the neutral rate of interest in the Euro Area is higher than last decade. Bottom Line: The €STR curve is pricing in the potential path of the ECB this year too aggressively. The ECB is likely to start raising rates in December, not in July. Domestic inflation and inflation expectations remain too modest, while the periphery remains fragile. Moreover, the ECB will stick to the previously decided sequence that calls for an end to net asset purchases ahead of hikes. Beyond 2022, we expect the ECB to increase rates more than what is priced into the €STR curve. Investment Implications The first implication of our view is that the European yield curve is likely to steepen further in the coming year. This is true in absolute terms but also relative to the US. We remain long European steepeners relative to US ones. Second, we continue to favor European financials. European banks are a direct equity play on higher yields and on a steeper yield curve (Chart 19). Moreover, European financials have upside relative to their US competitors. They are cheap, and they will benefit from the relative steepening in the European yield curve (Chart 20). Additionally, European monetary conditions will remain easier this year than US ones, whereas European growth will continue to catch up to the US. Chart 20Roll Over XLF Chart 19Banks Will Shine More Chart 21A Bit More Stress Third, the equity market correction might have a little more to run. In the near term, equities had become very oversold. This week’s bounce makes sense after the S&P 500’s RSI plunged below 30. However, hedge funds are not shorting the market as violently as they did in 2018, yet all the major global central banks (apart from the BoJ) are abandoning their pandemic-driven policy. As a result of the prospect of a global decline in liquidity, a retest of the 2018-lows in net exposure is likely as we approach the March Fed meeting, especially as credit spreads are still too low to cause a meaningful change in tone by the Fed (Chart 21). Thus, European stocks could experience another wave of selling in the coming weeks, especially when the risks surrounding Ukraine have yet to clear. Keep some protections in place. Finally, the euro has surged this week. With looming Ukrainian risk, the potential for a repricing downward of the near-term European policy rates and the risk of a last sell-off in equities, the euro could give up some of its recent gains and remain in a churning pattern, in place since December 2021. The uncertainty is therefore elevated for near-term traders. However, considering last week’s ECB pivot and the likelihood of an upward revision of the €STR curve for 2024 rates, long-term investors should use a pull back in the euro in the coming weeks to gain exposure to long EUR/USD. What About The BoE? Last week, the Bank of England increased rates by 25bps to 0.5%, which was a widely expected move. The BoE is naturally ahead of the ECB because inflation swaps stand at 4.3% and are even higher than those in the US. The BoE is forced to be more aggressive because inflation expectations are becoming unmoored, which raises the risk of a wage-price spiral north of the Channel. This is a legacy of years of higher inflation and of the labor-supply problems created by Brexit. Additionally, the UK is exiting Omicron lockdowns faster than the Euro Area, which accentuates its near-term economic strength. The UK is not, however, out of the woods. A perfect storm is brewing for the remainder of the year. Interest rates are set to rise sharply, energy price caps will disappear in two months, and the budget is anticipating a significant tightening in the coming quarters after taxes rise in April. This will hurt economic activity in the latter half of the year and will cause tensions in the domestic market. The tax hikes are not guaranteed and a reversal is still possible. PM Boris Johnson is currently embroiled in the so-called “Partygate” scandal and Rishi Sunak, Chancellor of the Exchequer, is seen as the most likely candidate within the Conservative Party to replace Johnson if he were to be pushed out of power by the 1922 Committee. As a colleague observed, it remains to be seen whether Sunak’s political ambitions will scuttle his fiscal rectitude. Nonetheless, the threats to UK small-cap stocks are increasing, warranting a cautious stance if the tax increases are not revoked in the coming weeks. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades
According to BCA Research’s Foreign Exchange Strategy service the US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US, and tightening financial conditions that will…
BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Recommendation Inception Level Inception Date Return Long AUD/NZD 1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 - Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar Chart 5BUS Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January. The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position. Chart 6AEuro Chart 6BEuro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic. The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Chart 7BJapanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term. Chart 8ABritish Pound Chart 8BBritish Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Chart 9BAustralian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar Chart 10BNew Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors. Chart 11ACanadian Dollar Chart 11BCanadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well. Chart 12ASwiss Franc Chart 12BSwiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December. Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis. Chart 13ANorwegian Krone Chart 13BNorwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Chart 14BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary
BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The tensions between Russia and the West over Ukraine are boiling over, as the risk of a conflict escalates. Following Washington’s written response to Moscow’s demands, BCA’s Geopolitical Strategy team now assigns a 75% probability to a Russian invasion of its neighbor. Matt Gertken, the team’s Chief Strategist, sees only a 10% chance that Russia will aim to conquer the whole of Ukraine. European markets are vulnerable to a Russian retaliation, and so we recommend hedging exposure to Europe and cyclical assets until the situation clears up. The euro remains at risk as long as tensions fester. Who Is Most Vulnerable To A Russian Energy Embargo? Bottom Line: Buy hedges such as short EUR/JPY and short EUR/CHF to protect portfolios against the risk of a conflict in Ukraine. The euro has more downside from here. Feature Handicapping The Risk Of War On Wednesday, after weeks of tense discussions, the US sent back its formal written response to Russia’s demands. Upon analysis of the situation, our geopolitical team concluded that the Biden administration offered no significant concessions. The US will not stop providing weapons to Ukraine, which, from Russia’s perspective, implies that its largest occidental neighbor could become “Russia’s Taiwan, i.e. a foreign-backed military enemy on its door step.” Matt Gertken, BCA’s Geopolitical Strategy team’s Chief Strategist, believes that the probability of a diplomatic solution has fallen to 25%, despite the joint statement made by Russia, Ukraine, France, and Germany on January 26, which reaffirms the ceasefire in the Donbass region of Ukraine. Any minor violation of the ceasefire’s terms by Ukraine will create an excuse for a Russian invasion. The nature of the eventual conflict will be crucial to the economic and market outlook for Europe. Matt argues that Europeans are hamstrung by their large dependence on Russian energy. Even switching to US LNG in case of a crisis this winter will not fill the full gap and cause major economic distress in Europe. As a result, European governments will try to avoid a war in order to limit sanctions so that Russia does not cut energy supply further. However, Europeans are also allied with the US, which will push for sanctions and which is not as afraid of the consequences of a conflict. Faced with this dichotomy, Matt argues that the most likely outcome is that Russia will ultimately concentrate on the Eastern Ukraine. He observes that “Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus, Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession.” In terms of the breakdown of probabilities, he sees a 65% probability of a short conflict whereby the battle is to control Eastern Ukraine, a 10% probability of a Russian effort to conquer the entire country, and a 25% probability of a diplomatic solution. According to Matt, it is too soon to buy the dip. Even if the situation on the ground matches our base case scenario of a limited conflict, Russia will employ a shock-and-awe strategy, creating the first major conflict on European soil since World War II. This will surprise investors and cause a knee-jerk spike in European energy prices. It will produce downside in the euro and in the relative performance of European equities, especially as it could take a few weeks before it becomes clear whether Russian troops will permanently cross the Dnieper. Bottom Line: European markets should brace for some volatility caused by Ukrainian events in the coming weeks. BCA’s geopolitical strategy team assigns only a 25% probability to a diplomatic resolution to the current tensions, a 65% probability to a limited Russian incursion in Ukraine, and a 10% chance of a war for the entire Ukrainian nation. Economic Risks Chart 1A Large Energy Shock For A Recession The economic implications of our base case scenario – a limited conflict – are restricted. As we showed three months ago, energy consumption only represents roughly 2% of European GDP. It would require a durable shock associated with a drawn-out conflict – the 10% probability scenario – to push up this ratio to the levels reached before the GFC, when energy prices were squeezing Europe (Chart 1). Nonetheless, markets will price in this probability as the conflict starts. Thus, understanding which economy is more vulnerable will help assess the risks to the market. The first metric to gauge vulnerability is the role of fossil fuels in the energy mix of European countries. In the event that a conflict causes an increase in energy prices, countries that rely more heavily on fossil fuel will experience a greater shock. On this front, pre-pandemic data from Eurostat shows that the Netherlands, Ireland, Poland, Greece, and Germany are the most exposed nations (Chart 2). By contrast, Sweden, Finland, France, and Denmark are the least exposed as a result of the role of nuclear or wind power generation in these countries. Chart 2Who depends Most On Fossil Fuel? Another metric is the share of a nation’s energy needs fulfilled by imports (Chart 3). On this score, Belgium, Italy, Spain, Greece, and Portugal are the most vulnerable nations, whereas Sweden, the UK, Denmark, and Czechia are the least at risk. Chart 3Who Depends Most On Imported Energy? We can also concentrate on the impact of the risk of a Russian embargo on energy shipments to Western Europe. Chart 4 shows that, when it comes to crude oil, Finland, Poland, Hungary, and, to a lesser extent, Czechia are most vulnerable, whereas Austria, Spain, and Ireland are the least at risk. With respect to natural gas, which is crucial to electricity generation, Czechia, Finland, and Hungary are the three most vulnerable countries, whereas Sweden, Austria, Ireland, and Denmark are not (Chart 5). Chart 4Who Depends Most On Russian Oil? Chart 5Who Depends Most On Russian Natural Gas? We may also combine all these measures and approximate the share of the total energy needs of European countries fulfilled by Russia. Our Vulnerability Index shows that the most exposed nation is by far Hungary, followed by Poland, Germany, Czechia, and Italy (Chart 6). This ranking helps explain why the German government’s support for Ukraine remains somewhat tepid, and why Italian businessmen still held a video call with Russian president Vladimir Putin as recently as last Wednesday. Chart 6Who Is Most Vulnerable To A Russian Energy Embargo? Bottom Line: Hungary, Poland, Germany, Czechia, and Italy are the European nations most exposed to an energy crisis in the event of a drawn-out, all-out war in Ukraine, whereas Austria, Sweden, Denmark, Ireland, and the UK are the least exposed. This scenario carries only a 10% probability, but understanding its impact is important, since investors will have to adjust their expectations once a conflict begins in the Ukraine. The ECB Response The ECB response to a Ukrainian conflict will depend on the nature of the war. In our base case scenario involving a limited assault focused on Eastern Ukraine, the ECB will look at any energy shock and its impact on inflation as temporary. European wage gains remain limited (Chart 7), and the Governing Council will assume that any spike in energy prices will not last long enough to dislodge European inflation expectations. This picture will be very different if Russia tries to conquer Western Ukraine as well. While the potential energy embargo will most likely cause a European recession, it will also risk pushing up inflation expectations permanently. Because expectations are already close to the ECB’s objective (Chart 8), the ECB will respond by tightening policy, which many members of the GC will want. This action is likely to accentuate any recessionary pressures in Europe. Again, we cannot stress enough that this constitutes a tail risk and is not our base case scenario. Chart 7European Wage Growth Remains Tame Chart 8Inflation Expectations Could Become Unmoored Market Implications The Euro Three weeks ago, we wrote that the euro was not ready to bottom because the risks associated with a slowing Chinese economy, the continued economic impact of Omicron, and the volatility of the natural gas market were still too considerable. Chart 9Another Wave Of Euro Selling This is even more true after last week’s Fed press conference, when FOMC Chair Jerome Powell did not contest the aggressive market pricing in the OIS curve. As a result, the window remains open in the near-term for interest rate differentials to move in a euro-bearish fashion (Chart 9). Ukraine adds another near-term threat to the euro. First, the run-up to an invasion, whether total or partial, will create a risk-off wave in global markets. Geopolitically driven sell-offs are most often associated with a rise in the counter-cyclical dollar, which is euro-bearish. The Swiss franc too would benefit against the euro. Moreover, Europe is much more exposed than the US to the economic consequences of a Ukrainian crisis. Obviously, our base case scenario implies a shorter and shallower sell-off than what would happen if Russia tried to conquer the whole of Ukraine. Nonetheless, a move below EUR/USD 1.10 now carries a greater than 40% probability. Bunds In our base case scenario of a limited Russian incursion in Ukraine, we should see a temporary dip in German yields driven by risk aversion. However, larger economic forces continue to point toward higher yields around the world, including in Germany. In our tail risk scenario, the German yield curve is likely to invert. ECB rate hikes will not be enough to push up 10-year yields, as markets will reflect that these increases will be temporary because of the associated recession. Instead, German 10-year yields will regress toward their 2021 lows of -0.55%. Equities Chart 10European Stocks Are Now Cheap Since mid-December, European equities have been outperforming US equities on the back of rising yields. We expect European shares to continue to outperform US stocks over the remainder of the year. As we wrote two weeks ago, European stocks possess a more generous valuation cushion against higher yields than their US counterparts, especially now that forward multiples have fallen back to 15.4, their lowest levels since May 2020 (Chart 10). Moreover, the greater cyclicality of European stocks means that they will benefit from an eventual stabilization of the Chinese economy by the latter half of 2022. They also stand to gain from a gradual normalization of the terminal rate proxy over the coming years, which often coincides with an outperformance of value stocks over growth names. Despite this positive outlook, the Ukrainian crisis poses a considerable near-term risk, even in the base case scenario of a limited Russian military aim. The wave of risk aversion will hurt the euro, which arithmetically will weigh on the relative performance of European stocks in common currency terms. Moreover, the more pro-cyclical profile of European stocks will accentuate their vulnerability in a geopolitical crisis. However, the temporary nature of the risk-off wave means that the woes suffered by Europe will also be transitory. Under the tail risk scenario, European equities will not be capable of outperforming those of the US for many months because of the high recession risk that will engulf the region. High energy prices will destroy the profit margins of European companies, which will already suffer from a hit to their top line-growth. US equities will suffer too, but significantly less so. Chart 11European Cyclicals Are Exposed To A Crisis In Ukraine Sector wise, a Ukrainian crisis will also short circuit the outperformance of European cyclicals over defensive equities. For now, European cyclicals have managed to generate alpha, despite the market correction (Chart 11), but the risk of a recession will affect this trend. Under our base case scenario, the underperformance will be short-lived, even if it proves severe; however, under the tail risk scenario, the cyclicals-to-defensives ratio will plunge toward the bottom of its historical range. Within defensive sectors, utilities will likely underperform, especially if the tail risk scenario comes to fruition. European governments will not allow utilities to pass on the full increase in natural gas prices to consumers, which will create a major compression in utilities’ profit margins. For cyclical names, consumer discretionary will bear the brunt of any sell-off. They are relatively pricey and the combination of the potential shock to household disposable income and rising risk aversion will prove to be lethal. The sales and profit margins of industrials will be under stress. However, this shock will be transitory if the Ukrainian crisis remains contained in our base-case scenario. Chart 12The Russian Exposure Of European Banks Financials carry their own risk in the context of a drawn-out Ukrainian crisis. European banks have exposure to Russia equal to $106 billion, concentrated in France and Switzerland (Chart 12). In and of itself, this is small. However, if European nations impose large enough sanctions on Russia, not only will that country cut its energy shipments to Western Europe, but Russian firms will also likely default on their foreign obligations, emboldened by Russia’s robust FX reserves and balance of payments. In the context of a recession wherein the ECB also hikes rates, these defaults will add considerable stress to the European banking sector. Thus, under our tail risk scenario, financials could perform particularly poorly. In terms of the implications for countries, Germany is the most exposed of all the major European markets to a Ukrainian crisis because of its high energy dependence on Russia and fossil fuels. The recent underperformance of German equities when we correct for sectoral bias probably already reflects the recent rise in electricity costs in the country, which hurt German firms versus their European competitors (Chart 13). While we like the fundamentals of European small-cap stocks, we have remained on the sidelines because of the strong correlation between their relative performance and the trade-weighted euro (Chart 14). The risks surrounding Ukraine and their implications for both the euro and the European economy suggest it is still too dangerous to pull the trigger and overweight small-cap in Europe. However, if our base case scenario of a limited conflict comes true, then this will create the perfect opportunity to move into the European small-cap space. Chart 13German Suffers A Nat Gas Discount Chart 14Small-Caps Need A Euro Bottom Investment Implications Considering the probability distribution laid out by BCA’s Geopolitical Strategy team, whose base case scenario is a limited Russian incursion into Ukraine, we do not expect NATO countries to impose sanctions severe enough to force Russia to cut Western Europe’s energy supply. Nonetheless, the prospect of the most significant military conflict on European soil since World War II will have a significant impact on European asset prices, even if this effect is transitory. As a result, we still maintain our preference for cyclical equities in Europe and still expect European equities to outperform US stocks over the course of 2022. We also continue to anticipate that European stocks will outperform Bunds in 2022. Nonetheless, ahead of the conflict, we recommend investors buy some hedges, such as short EUR/CHF and EUR/JPY to protect against downside risk. Rapidly after the conflict begins, an opportunity to close those hedges will emerge. With respect to the euro, the combined stress from a hawkish Fed and Ukrainian risks means we will stay on the sidelines after having been stopped out of our long EUR/USD trade. If our base case of a limited conflict does come to fruition and Russia instead initiates a full invasion of Ukraine, we will shift our portfolio to a fully defensive stance. The euro could re-test parity or even drop below it. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance