Currencies

Counterpoint’s August schedule: Next week, I am travelling to see clients in Australia, New Zealand, and Singapore, so we will send you a report on China’s 20th National Party Congress written by our Chief Geopolitical Strategist, Matt Gertken. Given that the outlook for the $100 trillion Chinese real estate market is crucial for the global economy and markets, Matt’s insights will be very interesting. Then on August 18, I will host the monthly Counterpoint webcast, which I hope you can join. We will then take a week’s summer holiday and return with a report on September 1. Executive Summary In the topsy-turvy recession of 2022, real wages have collapsed. This means profits have stayed resilient and firms have not laid off workers. Making this recession a ‘cost of living crisis’ rather than a ‘jobs crisis’. If inflation comes down slowly, then the ‘cost of living crisis’ will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  The double choke on growth means that the bear market in the 30-year T-bond is likely over. This suggests that the bear market in stock market valuations is also over, but that ‘cyclical value’ is now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal trading watchlist: GBP/USD and Hungarian versus Polish bonds. In The 2008 Recession, Real Wage Rates ##br##Went Up So Employment Went Down… …But In The 2022 Recession, Real Wage Rates##br##Went Down So Employment Went Up! Bottom Line: The bear market in the 30-year T-bond and stock market valuations is likely over, but equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Feature The US economy has just contracted for two consecutive quarters, meeting the rule-of-thumb definition of a recession. Other major economies are likely to follow. Yet many economists and strategists are in denial. This cannot be a ‘proper’ recession, they say, because the economy remains at full employment. But the recession-deniers are wrong. It is a recession, albeit it is a ‘topsy-turvy’ recession in which employment remains high (so far) because real wage rates have collapsed, circumventing the need for lay-offs. This contrasts with a typical recession when real wage rates remain high, forcing the need for lay-offs.1 The Topsy-Turvy Recession Of 2022 When do firms lay off workers? The answer is, when they need to protect their profits. Profits are nothing more than revenues minus costs, and in a typical recession revenues slow much faster than the firms’ biggest cost, the wage bill. In this event, the only way that firms can protect their profits is to lay off workers. Chart I-1 confirms that every time that nominal sales have shrunk relative to wage rates, the unemployment rate has gone up. Without exception. Chart I-1Unemployment Goes Up Whenever Firms' Wage Rates Rise Faster Than Their Revenues... But what happens during a recession in which nominal sales do not shrink relative to wage rates? In this event, profits stay resilient, so firms do not need to lay off workers. Welcome to the topsy-turvy recession of 2022! In the topsy-turvy recession of 2022, there has been much greater inflation in consumer prices and nominal sales than in nominal wage rates (Chart I-2). The result is that real wage rates have collapsed, profits have stayed resilient, and firms have not needed to lay off workers… so far. Chart I-2...But In The 2022 Recession, Wage Rates Have Risen Slower Than Revenues, So Unemployment Hasn't Gone Up In a typical recession, the pain falls on the minority of workers who lose their jobs, as well as on profits. Paradoxically, for the majority that keep their jobs, real wages go up. This is because sticky wage inflation tends to hold up more than collapsing price inflation. For example, in the 2008 recession, the real wage rate surged by 4 percent (Chart I-3), and in the 2020 recession it rose by 2 percent. Chart I-3In The 2008 Recession, Real Wage Rates Went Up So Employment Went Down... Yet in the 2022 recession, the real wage rate has shrunk by 4 percent, meaning that the pain of the recession has fallen on all of us (Chart I-4). In one sense therefore, this recession is ‘fairer’ because ‘we’re all in it together’. This is confirmed by the current malaise being characterised not as a ‘jobs crisis’, but as a ‘cost of living crisis’. In another sense though, the recession is unfair because the pain has not been shared by corporate profits, which have remained resilient… so far. Chart I-4...But In The 2022 Recession, Real Wage Rates Went Down So Employment Went Up! The crucial question is, what happens next? Using the US as our template, wage rates are growing at 5-6 percent, and this growth rate is typically stickier than sales growth. Assuming inflation drifts lower, nominal sales growth will also drift lower from its current 7 percent clip, meaning that it could soon dip below sticky wage growth. Once the growth in firms’ revenues has dipped below that in nominal wage rates, profits will finally keel over. To repeat, profits are nothing more than revenues minus costs, where the biggest cost is the wage bill (Chart I-5).2 Chart I-5Profits Are Nothing More Than Revenues Minus Costs At this point, the downturn will become more conventional. To protect profits, firms will be forced to lay off workers who will bear the pain of the downturn alongside falling profits. Meanwhile, with inflation easing, real wage growth for the majority that keep their jobs will turn positive. But to repeat, this is the typical pattern in a recession. Accelerating real wage rates are entirely consistent with a contracting economy as we witnessed in both 2008 and 2020.  As Two Huge Imbalances Correct, Demand Will Be Pegged Back All of this assumes that real demand will remain under pressure, so the question is what is pegging back real demand? The answer is: corrections in two huge imbalances in the global economy. A breakdown of the -1.3 percent contraction in the US economy reveals these two corrections:3   Spending on goods, which contributed -1.2 percent Housing investment, which contributed -0.7 percent. These corrections are not over. As we presciently explained back in February in A Massive Economic Imbalance, Staring Us In The Face: “The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. The pandemic overspend on goods constitutes one of the greatest imbalances in economic history. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a recession. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation” (Chart I-6). Chart I-6The Pandemic Overspend On Goods Constitutes One Of The Greatest Imbalances In Economic History Then, in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, we identified a second major imbalance that is starting to correct. Specifically, the global housing boom of the past decade, which has doubled the worth of global real estate to $370 trillion, was predicated on ultra-low mortgage rates that made buying a home more attractive than renting. But in many parts of the world now, buying a home has become more expensive than renting (Chart I-7). Disappearing US and European homebuyers combined with a flood of home-sellers will weigh on home prices and housing investment – at least until policymakers are forced to bring down mortgage rates (Chart I-8 and Chart I-9). Chart I-7Buying A Home Has Become More Expensive Than Renting! Chart I-8Homebuyers Have Disappeared... Chart I-9...While Home-Sellers Are Flooding The Market Meanwhile, as Chinese policymakers try and gently let the air out of the $100 trillion Chinese real estate market, a collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. More Investment Conclusions In addition to the long-term investment conclusions just described, we can draw some shorter-term conclusions: If inflation comes down slowly, then the current ‘cost of living crisis’, which is pummelling everyone’s real incomes, will persist. But if inflation comes down quickly while wage inflation remains sticky, firms will be forced to lay off workers to protect their profits, turning the ‘cost of living crisis’ into a ‘jobs crisis’. Either way, this will keep a choke on consumer spending, and particularly the spending on goods, which is likely to remain in recession. Meanwhile, until mortgage rates move meaningfully lower, housing investment will also remain in recession.  Equityinvestors should stick with ‘defensive growth’, specifically healthcare and biotech. This double choke on growth is likely to keep a lid on ultra-long bond yields, even if central banks need to hike short-term rates more than expected to slay inflation. Our proprietary fractal analysis confirms that the sell-off in the 30-year T-bond is likely over (Chart I-10). Chart I-10The Bear Market In The 30-Year T-Bond Is Likely Over For the stock market, this suggests that the valuation bear market is now over, but that ‘cyclical value’ sectors are now vulnerable to profit downgrades. Hence, equity investors should stick with ‘defensive growth’, specifically healthcare and biotech. Fractal Trading Watchlist This week we noticed that the sudden 20 percent collapse of Hungarian versus Polish 10-year bonds, has reached the point of short-term fractal fragility that suggests an imminent rebound. Hence, we are adding this to our watchlist. Go long GBP/USD. But our trade is GBP/USD. UK political risk is diminishing, the BoE is likely to be as, or more, hawkish than the Fed, and the 260-day fractal structure of GBP/USD is at the point of fragility that has signalled major turning points in 2014, 15, 16, 18 and 21 (Chart I-11). Accordingly the recommendation is long GBP/USD, setting the profit target and symmetrical stop-loss at 5 percent.   Chart I-11Go Long GBP/USD Expect Hungarian Bonds To Rebound Chart 1CNY/USD At A Potential Turning Point   Chart 2Expect Hungarian Bonds To Rebound Chart 3Copper's Selloff Has Hit Short-Term Resistance Chart 4US REITS Are Oversold Versus Utilities Chart 5CAD/SEK Is Reversing Chart 6Financials Versus Industrials Has Reversed Chart 7The Outperformance Of Resources Versus Biotech Has Ended Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 10Netherlands' Underperformance Vs. Switzerland Has Ended Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 13Food And Beverage Outperformance Is Exhausted Chart 14German Telecom Outperformance Has Started To Reverse Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Chart 16ETH Is Approaching A Possible Capitulation Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 18The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Has Ended Chart 22Cotton Versus Platinum Has Reversed Chart 23Switzerland's Outperformance Vs. Germany Is Exhausted Chart 24USD/EUR Is Vulnerable To Reversal Chart 25The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 26A Potential New Entry Point Into Petcare Chart 27US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The best measure of wage rates is the employment cost index (ECI) because it includes all forms of compensation including benefits and bonuses. 2  In fact, stock market profits are even more cyclical because, as well as wages, there are other sticky deductions from revenues such as interest and taxes. 3 All expressed as annualised rates. Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Listen to a short summary of this report.     Executive Summary Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Following last week’s sharp post-FOMC rally, we shifted our 12-month equity recommendation from overweight to neutral. We expect stock prices to rise further during the remainder of the year as US recession risks abate, but then to give up most of their gains early next year as it becomes clear that the Fed has no intention of cutting rates and may even need to raise rates. We have more conviction that US growth will hold up over the next 12 months than we do that inflation will fall as fast as the Fed expects or the breakevens imply. These varying degrees of conviction stem from the same reason: The neutral rate of interest in the US is higher than widely believed. A high neutral rate implies that it may take significant monetary tightening to slow the economy. That reduces the risk of a recession in the near term, but it raises the risk that inflation will remain elevated. A recession is now our base case for the euro area. However, we expect the European economy to bounce back early next year, as gas supplies increase and fiscal policy turns more stimulative. The euro has significant upside over the long haul. Bottom Line: Stocks will continue to recover over the coming months before facing renewed pressure early next year. We are retaining our tactical (3-month) overweight on global equities but are shifting our 12-month recommendation to neutral. Taking Some Chips Off the Table Following last week’s sharp post-FOMC rally, we shifted our cyclical 12-month equity recommendation from overweight to neutral. This note lays out the key considerations in a Q&A format.   Q: Have any of your underlying views about the economy changed recently or has the market simply moved towards pricing in your benign outlook? A: Mainly the latter. While we continue to see a higher-than-normal risk of a US recession over the next 12 months, our baseline (60% odds) remains no recession.   Q: Many would say that we are in a recession already. A: While two consecutive quarters of negative growth does not officially constitute a recession, it is correct to say that every time real GDP has contracted for two quarters in a row, the NBER has ultimately deemed that episode a recession (Chart 1). Chart 1In The Past, Two Consecutive Quarters Of Negative Growth Have Always Coincided With A Recession That said, one should keep two things in mind. First, preliminary GDP estimates are subject to significant revisions. According to our calculations, there is a 35% chance that real GDP growth in Q2 will ultimately be revised into positive territory (Chart 2). Even Q1 may eventually show positive growth. Real Gross Domestic Income (GDI), which conceptually should equal GDP, rose by 1.8% in Q1. Chart 2After Further Revisions, It Is Possible That GDP Growth Ends Up Being Positive In Q2 2022 Second, every single US recession has seen an increase in the unemployment rate (Chart 3). So far, that has not happened, and there is good reason to think it will not happen for some time: There are 1.8 job openings per unemployed worker (Chart 4). For the foreseeable future, most people who lose their jobs will be able to walk across the street to find a new one. Chart 3Recessions And Spikes In The Unemployment Rate Go Hand-In-Hand Chart 4A High Level Of Job Openings Creates A Moat Around The Labor Market   Chart 5Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Q: Aren’t other measures of economic activity such as the ISM, consumer confidence, and homebuilder sentiment all signaling that a major slowdown is in progress? A: They are but we should take them with a grain of salt. The composition of consumer spending is shifting from goods to services. This is weighing on manufacturing output. As Chart 5 shows, goods spending has already retraced two-thirds of its pandemic surge, with no ill effects on the labor market. Consumer confidence tends to closely track real wages (Chart 6). Despite an extraordinarily tight labor market, real wages have been shrinking all year. As supply-chain bottlenecks abate, inflation will fall, allowing real wages to rise. This will bolster consumer confidence and spending. Falling gasoline prices will also boost disposable incomes. Prices at the pump have fallen for seven straight weeks and the futures market is pointing to further declines in the months ahead (Chart 7). Chart 6Falling Inflation Will Boost Real Wages And Consumer Confidence Chart 7The Futures Market Points To Further Declines In Gasoline Prices It is also critical to remember that the Fed is trying to slow the economy by tightening monetary policy. At the start of the year, investors expected the Fed funds rate to be 0.9% in early 2023. Today, they expect it to be 3.4% (Chart 8). Chart 8Investors Are Pricing In A Much More Aggressive Tightening Cycle Than At The Start Of The Year Chart 9Housing Activity Should Recover Now That Mortgage Rates Have Stabilized   Rising rate expectations curb aggregate demand. This temporarily leads to lower growth. However, once rate expectations stabilize – and demand resets to a lower level – growth will tend to return to trend. The 6-month mortgage yield impulse has already turned up. This suggests that housing and other interest-rate sensitive parts of the economy will begin to recover by the end of the year (Chart 9). Admittedly, if the unemployment rate rises in response to lower aggregate demand, this could set off a vicious circle where higher unemployment leads to less spending, leading to even higher unemployment. However, as noted above, given that the current starting point is one where labor demand already exceeds labor supply by a wide margin, the odds of a such a labor market doom loop are much lower than during past downturns.   Q: Does the question of whether we officially enter a recession or not really matter that much? A: It is a matter of degree. As Chart 10 shows, macroeconomic factors are by far the most important determinant of equity returns over medium-term horizons of about 12 months. As a rule of thumb, bear markets almost always coincide with recessions (Chart 11). Chart 10Macro Forces Are An Important Driver Of Equity Returns On Cyclical Horizons Chart 11Equity Bear Markets And Recessions Go Hand-In-Hand   Chart 12Soaring Energy Prices Have Boosted Earnings Estimates This Year Q: Are you surprised that earnings estimates have not come down faster this year as economic risks have intensified? A: Most analysts have not baked in a recession in their forecasts, so from that perspective, if our baseline scenario of no recession does not pan out, earnings estimates will almost certainly come down (Chart 12). That said, the bar for major downward earnings revisions is quite high. This is partly because we think that if a recession does occur, it is likely to be a mild one. It is also because earnings are reported in nominal terms. In contrast to real GDP, nominal GDP grew by 6.6% in Q1 and 7.8% in Q2.   Q: Let’s turn to interest rates. Why do you think the Fed will not cut rates next year as markets are discounting? A: It all boils down to the neutral rate of interest. In past reports, we made the case that the neutral rate in the US is higher than widely believed. The fact that job vacancies are so plentiful provides strong evidence in favor of our thesis. If the neutral rate were low, the labor market would not have overheated. But it did, implying that monetary policy must have been exceptionally accommodative. The good news for investors is that a high neutral rate implies that the Fed is unlikely to induce a recession by raising rates in accordance with its dot plot. That reduces the risk of a recession in the near term. The bad news is that a high neutral rate will essentially preclude the Fed from cutting rates next year. The economy will simply be too strong for that. Worse still, if the Fed is too slow in bringing rates to neutral, inflation – which is likely to fall over the coming months as supply-chain pressures ease – could reaccelerate at some point next year. That could force the Fed to start hiking rates again.   Chart 13Real Yields Have Scope To Rise Further Q: What is your estimate for the neutral rate in the US? A: In the past, we have written that the neutral rate in the US is around 3.5%-to-4%. However, I must admit, I’m not a big fan of this formulation. Real rates matter more for economic growth than nominal rates, and long-term rates matter more than short-term rates. Thus, a better question is what level of real long-term bond yields is consistent with stable inflation and full employment. Based on research we have published in the past, my best bet is that the neutral long-term real bond yield is between 1.5%-and-2%. That is substantially above the 10-year TIPS yield (0.27%) and the 30-year TIPS yield (0.79%) (Chart 13). Given that the yield curve is inverted, the Fed may have to raise policy rates well above 4% in order to drag up the long end of the curve. It is a bit like how oil traders say you need to lift spot crude prices in order to push up long-term futures prices when the oil curve is backwardated.   Chart 14Investors Expect Inflation To Fall Rapidly Over The Next Few Years Q: So presumably then, you would favor a short duration position in fixed-income portfolios? A: Yes, if the whole yield curve shifts higher, you will lose a lot less money in short-term bonds than in long-term bonds. Relatedly, we would overweight TIPS versus nominal bonds. The TIPS market is pricing in a very rapid decline in inflation over the next few years (Chart 14). The widely followed 5-year, 5-year forward TIPS inflation breakeven rate is trading at 2.28%, toward the bottom end of the Fed’s comfort zone of 2.3%-to-2.5%.1   Q: What about credit? A: US high-yield bonds are pricing in a default rate of 6.1% over the next 12 months. This is up from an expected default rate of 3.8% at the start of the year and is significantly higher than the trailing 12-month default rate of 1.4%. In a typical recession, high-yield default rates rise above 8% (Chart 15). Thus, spreads would probably increase if the US entered a recession. That said, it is important to keep in mind that many corporate borrowers took advantage of very low long-term yields over the past few years to extend the maturity of their debt. Only 7% of US high-yield debt, and less than 1% of investment-grade debt, held in corporate credit ETFs matures in less than two years. This suggests that the default cycle, if it were to occur, would be less intense and more elongated than previous ones. Chart 15High-Yield Bonds Are Pricing In Higher Default Rates On balance, we recommend a modest overweight to high-yield bonds within fixed-income portfolios.   Chart 16High Energy Prices Are Weighing On The European Economy Q: Let’s turn to non-US markets. The dollar has strengthened a lot against the euro this year as the economic climate in Europe has soured. Can Europe avoid a recession? A: Probably not. European natural gas prices are back near record highs and business surveys increasingly point to recession (Chart 16). That said, the nature of Europe’s recession could turn out to be quite different from what many expect. There are a few useful parallels between the predicament Europe finds itself in now and what the global economy experienced early on during the pandemic. Just like the Novel coronavirus, as it was called back then, represented an external shock to the global economy, the partial cut-off in Russian energy flows represents an external shock to the European economy. Policymakers in advanced economies responded to the pandemic by showering their economies with various income-support measures. European governments will react similarly to the energy crunch. In fact, the political incentive to respond generously is even greater this time around because the last thing European leaders want is for Putin to succeed in his efforts to destabilize the region. For its part, the ECB will set an extremely low bar for buying Italian bonds and the debt of other vulnerable economies. Just like the world eventually deployed vaccines, Europe is taking steps to inoculate itself from its dangerous addiction to Russian energy. The official REPowerEU plan seeks to displace two-thirds of Russian natural gas imports by the end of the year. While some aspects of the plan are probably too optimistic, others may not be optimistic enough. For example, the plan does not envision increased energy production from coal-fired plants, which is something that even the German Green Party has now signed on to. The euro is trading near parity to the dollar because investors expect growth in the common-currency bloc to remain depressed for an extended period of time. If investors start to price in a more forceful recovery, the euro will rally.   Q: China’s economy remains in the doldrums. Could that undermine your sanguine view on the global economy? A: China’s PMI data disappointed in July, as anxiety over the zero-Covid policy and a sagging property market continued to weigh on activity (Chart 17). We do not expect any change to the zero-Covid policy until the conclusion of the Twentieth Party Congress later this year. After that, the government is likely to ease restrictions, which will help to reignite growth. Chart 17The Zero-Covid Policy And Slumping Property Market Are Weighing On Chinese Economic Activity Chart 18China Faces A Structural Decline In The Demand For Housing The property market has probably entered a secular downturn (Chart 18). If a weakening property market were to cause a banking crisis, similar to what happened in the US and parts of Europe in 2008, this would destabilize the global economy. However, we doubt that this will happen given the control the government has over the banking system. In contrast, a soft landing for the Chinese real estate market might turn out to be a welcome development for the global economy, as less Chinese property investment would keep a lid on commodity prices, thus helping to ease inflationary pressures. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn & Twitter   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Biden Can Take Risks Ahead Of Midterms News reports suggest House Speaker Nancy Pelosi will travel to Taiwan and meet with Taiwanese President Tsai Ing-wen in the coming days. China has promised military counter-measures if she visits. Structural factors suggest US-China tensions over Taiwan could explode: China’s reversion to autocracy and hawkish foreign policy, Taiwan’s assertion of autonomy, and the US’s political instability and foreign policy reactiveness. Cyclical factors also suggest that tensions could escalate: China’s instability in the wake of Covid-19, the ramifications of Russia’s invasion of Ukraine, the budding Russo-Chinese alliance, the Biden administration’s domestic political vulnerability, and the Xi administration’s domestic political vulnerability. In particular, Xi cannot back down. A diplomatic crisis or military showdown is likely in the short run but not yet a full-scale war. Taiwan is harder to invade than Ukraine, the US is not attempting a radical boost to Taiwan’s military, Taiwan is not moving toward formal independence, and the Chinese economy is not yet collapsing beyond all hope. However, over the long run we fear that a Taiwan war is more likely than not. Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Investors should short Chinese and Taiwanese currencies and assets. Tactical Recommendation Inception Date Return LONG US SEMICONDUCTOR & SEMI EQUIPMENT / TAIWAN EQUITIES 2022-06-23 14.6% LONG KOREA/ SHORT TAIWAN EQUITIES 2020-03-27 -23.5% Bottom Line: Tactically investors should buy safe-haven assets and await a resolution of the US-China confrontation over Taiwan, which could cause a dramatic escalation in strategic tensions. Feature A fourth Taiwan Strait crisis is likely upon us. Speaker of the US House of Representatives Nancy Pelosi will visit Taiwan during her travel around Asia Pacific this week, according to the Wall Street Journal on August 1. Chinese President Xi Jinping warned US President Joe Biden in a phone conversation on July 28 that “those who play with fire will eventually get burned,” referring specifically to US relations with Taiwan. Chinese foreign ministry officials have threatened “forceful” countermeasures if Pelosi visits the island, explicitly saying that the People’s Liberation Army would respond in some way.   There is still some uncertainty over whether Pelosi will go. She delayed the trip in April. Rumors emerged over July that she would resume but President Joe Biden suggested on July 20 that US military officials opposed the trip, believed the timing to be inappropriate. Taiwan was not mentioned in Pelosi’s official itinerary published on July 31, which includes Singapore, Japan, South Korea, and Malaysia. But the Wall Street Journal report has been corroborated by US and Taiwanese officials. Assuming Pelosi goes, China will respond with some military show of force. The US may pretend that one hand (the White House, the Department of Defense) does not know what the other hand is doing (the House of Representatives). But China will not be convinced. There are three major reasons that we have predicted a fourth Taiwan Strait crisis: 1.   China’s reversion to autocracy and foreign policy hawkishness: After the Great Recession, China was forced into a painful downshift in potential economic growth, stemming from a contracting labor force, excessive debt, and changes in the international economy (Chart 1). As economic growth has slowed, China has pursued political centralization, economic mercantilism, military modernization, and foreign policy assertiveness, offering nationalism as a distraction from the disappointments of the new middle class. While China may not be ready to launch a full-scale invasion of Taiwan, it is willing to do so if the Communist Party regime’s survival is at stake. Chart 1China's Slowdown Leads To Hawkishness 2.   Taiwan’s reassertion of autonomy: Taiwanese people began to sour on mainland China with the Great Recession and increasingly developed an independent identity (Chart 2). China’s growing economic influence, combined with Xi Jinping’s re-centralization of power across Greater China, provoked a backlash in Taiwan beginning in 2013 that culminated in the nominally pro-independence Democratic Progressive Party gaining full control of the island in 2016. The US-China trade war, China’s imposition of control over critical buffer spaces (including the South China Sea and Hong Kong), and US export controls on advanced technologies thrust Taiwan into the middle of a strategic confrontation. While Taiwan is not seeking war or formal political independence, it is seeking closer ties with the US and democratic allies to protect against Beijing’s encroachment.     3.   US political instability and foreign policy reaction: The Great Recession brought the US’s latent political instability from a simmer to a boil. The Washington establishment withdrew from the war on terrorism only to face discontent at home and strategic competition from China and Russia. China intensified its acquisition of US technology while North Korea obtained a nuclear arsenal under China’s watch. A surge in populism led the US to initiate a trade war against China and to impose restrictions on critical technologies to slow China’s modernization. While the US political factions bickered over domestic policy, they both tapped into a popular consensus on economic nationalism and hawkishness toward China (Chart 3). While the US is struggling to curb Russia and Iran, its greatest long-term challenge stems from China and it is increasingly focused on containing China’s economy and strategic ambitions. Chart 2Taiwanese Souring On China Chart 3US Hawkish Consensus On China In addition, there are important cyclical reasons why investors should take very seriously the risk of a major geopolitical crisis emanating from Taiwan in the short run: The Covid-19 pandemic intensified US (and global) distrust of China and accelerated the divorce of the US and Chinese economies. It also threw the Chinese economy into a downward spin, threatening Xi Jinping’s personal security and the Communist Party’s regime security. Hypo-globalization reduces critical economic constraints on military conflict. The Ukraine war highlighted the willingness of ambitious strongman regimes to go to war to prevent neighboring countries from allying with the United States. Taiwan is critical to Chinese security just as Ukraine is critical to Russian. Taiwan, like Ukraine, lacks a mutual defense treaty with the US and yet is attempting to create a de facto treaty through political, economic, and military cooperation – a scenario that will incentivize Chinese military action if it ever believes the US will take irrevocable steps to increase its commitment to defend Taiwan. At the same time, the US will try to deter China more effectively, since its deterrence failed in the case of Ukraine, which entails upgrading the Taiwanese relationship. Hence China will feel threatened and accuse the US of altering the status quo. Russo-Chinese alliance prevents US-China reengagement. Russia threw itself into China’s arms by cutting off natural gas to Europe. China cannot reject Russia’s overture because it needs Russia’s alliance to break through American strategic containment in the coming years. China needs Russia’s natural resources and its cooperation in gaining economic access to Central Asia and the Middle East. The US cannot pursue strategic détente with China if China is allying with Russia, since a Russo-Chinese alliance poses an unprecedented threat to American global influence and security (Chart 4). The Democratic Party is desperate to mitigate looming election losses. President Biden’s approval rating has fallen to 39%, while headline inflation hits 9% and the economy slips into a technical recession. The Republican Party is lined up for a victory in the midterm elections, yet Democrats view the populist Republicans as an existential threat. Hence Biden and Democratic leaders like Pelosi are willing to take significant risks to salvage the election, including provoking foreign rivals. The administration is contemplating tougher export controls on China’s access to semiconductor manufacturing equipment and Congress is passing bipartisan legislation to make the US more competitive against China. Any major confrontation abroad would generate a patriotic rally among voters, as did the Cuban Missile Crisis in 1962, which saved the Democrats from heavy losses in the midterms that year (Chart 5). China’s domestic politics support a foreign confrontation. As Xi attempts to cement another five-to-ten years in power at the twentieth national party congress this fall, the pandemic restrictions, political repression, property bust, and economic slowdown ensure that he has little good news to celebrate at home. He could benefit from taking an aggressive stance against the imperialist Americans over Taiwan – and he cannot afford to back down or lose face. Ultimately China’s regime legitimacy is at stake in Taiwan so it is willing to take greater risks than the United States.   Chart 4US Cannot Engage With Russo-Chinese Behemoth Chart 5Biden Can Take Risks Ahead Of Midterms All of the above demonstrates that investors should not be complacent but should take risk off the table until the Pelosi trip blows over. A major diplomatic or geopolitical crisis will occur if Pelosi indeed visits Taiwan, for China will be required to react to uphold the credibility of its warnings, and Beijing will have a national and political interest in overreacting rather than underreacting. The Americans will then have a national and political interest in preserving their own credibility. This dynamic could lead to a major escalation in strategic tensions. Could a crisis lead to full-scale war? Yes it could but most likely it will not – at least not yet. Here are some important limitations, which investors should monitor closely. If these are reduced or overcome, then a larger conflict becomes more probable: Taiwan is harder to invade than Ukraine. Taiwan is an island and islands that are politically unified can only be subdued with enormous cost of blood and treasure even by the most powerful armies. Taiwan is critical to the global economy, unlike Ukraine. While it lacks defense treaties, it has stronger strategic partnerships than Ukraine did. The Chinese military has not fought an expeditionary war since Vietnam in 1979. The US sent aircraft carriers to the Taiwan Strait in each of the previous three crises since the 1950s, signaling that it is willing to defend Taiwan, and currently has at least two aircraft carriers in Asia Pacific (Map 1). China needs to be prepared for potential American and Japanese intervention if it is to attack Taiwan, which requires an advanced triad of nuclear arms.    Map 1US Aircraft Carriers Suggest Taiwan Risk Is Substantial The US is not sending any game-changing offensive weapon systems. Instead the US is sending a mere politician. China opposes anything resembling state-to-state relations but Taiwan’s defensive capability would not be improved. Hence China would not be forced to take aggressive military action. Instead China is attempting to set a very low bar for intervening in US-Taiwan political relations. Beijing can intervene in a way that enforces the new line but remains beneath the threshold of war. Going forward, US arms sales to Taiwan will be a much riskier affair and the delivery of a weapons system could trigger conflict (Chart 6). Chinese economy is not (yet) beyond help. China still has authoritarian powers to manipulate the domestic economy, suggesting that policy makers will intervene to slow down the property bust and stimulate activity. After Xi Jinping consolidates power, we expect a pro-growth strategy to be unveiled that will lead to a stabilization of growth in 2023. This is necessary for Xi to maintain domestic stability, which is existential to the regime and its long-term security. If stimulus and interventions fail utterly and China collapses into a full-blown financial crisis, then China will lose the ability to improve its security over the long run and the risk of conflict with foreign powers will rise. But as long as China’s economy is not collapsing, China maintains the prospect of building its influence and power over time and conquering Taiwan through absorption rather than extremely risky armed conflict (Chart 7). Chart 6US Arms Sales Could Trigger A Real Conflict Chart 7More Economic Stimulus Is Coming Taiwan is not moving toward formal independence. The Tsai Ing-wen administration is nominally in favor of independence but has chosen rhetorical sleight of hand over any formal change to Taiwan’s status. Taiwanese people support the status quo knowing that they will live in a war zone if they declare independence. The long-term problem stems from the fact that a clear majority opposes unification with the mainland (Chart 8). Taiwan and the US face elections in 2022 and 2024. If the Kuomintang stages a comeback in Taiwanese politics, or the Democrats win reelection in 2024, then China still has the ability to pursue its aims through diplomacy. Whereas if the Democratic Progressive Party remains in full control of Taiwan, and the Republicans regain the White House, Beijing may conclude that little can be gained through diplomacy. Especially if these US and Taiwanese parties proceed to press their interests aggressively. Chart 8Taiwanese Not Declaring Independence Hence the most likely outcome if Pelosi visits Taiwan is a US-China geopolitical crisis of some sort but not a full-scale war. A crisis short of war could establish a new set of red lines over Taiwan that could govern the US-China relationship in the medium term with reduced uncertainty. But it would bring very bad news in the short run and lead to a permanent deterioration in US-China relations and global stability over the long run, which markets must price first.   Bottom Line: Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Stay short Chinese and Taiwanese currencies and assets. While semiconductor stocks stand at risk, investors should favor US semiconductor companies over Chinese and Taiwanese (Chart 9). Chart 9Investors Should Seek Safe Havens Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.     Executive Summary The Dollar Rises During Recessions At 106.5, the dollar DXY index is certainly pricing in a recession deeper than during the Covid-19 crisis. The dollar tends to rise during recessions and only peaks when a global economic recovery is in sight (Feature Chart). One caveat: contrary to conventional wisdom, US economic data is deteriorating relative to the rest of the world. Historically, that has been a negative for the greenback. The key question facing investors is if markets are entering a riot point. That is a high probability. Historically, high volatility supports the dollar. As such, our recommended stance on the dollar is neutral over the next few months. Our highest conviction bets are short EUR/JPY and long Swiss franc trades. Valuations tend to matter when most investors least expect them to. On this basis, we are negative the dollar on a 12-to-18 month time horizon. Place a limit sell on CHF/SEK at 10.76.   TRADES* INITIATION DATE PERCENT RETURNS Short EUR/JPY 2022-07-21 2.73% Bottom Line: Stand aside on the dollar for now. Continue to opportunistically play trades at the crosses. Short EUR/JPY bets make sense as a volatility hedge.   Chart 1Any Dollar Bears Left? In our conversations with clients, it is rare to find a dollar bear these days. One barometer is price action – the dollar DXY index is up 18% from its 2021 lows. More instructively, net long speculative positions are near a multi-decade high (Chart 1). In our meetings, we sense a specter of capitulation among fundamental dollar bears, as the macroeconomic environment becomes more uncertain. For chart enthusiasts, the DXY index staged a classic breakout, and the next technical level is closer to the 2002 highs near 120. We doubt the DXY index will hit this level, as significant headwinds are building. It is true that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. But as we argue below, the dollar has already priced in a recession, deeper than was the case in 2020 (or admittedly, at any time since the end of the Bretton Woods system). This suggests that investors with a relatively benign economic backdrop should be fading any strength in the dollar. In other words, if your bet on a recession is low odds, fade dollar strength relatively to your colleagues. As such, our recommended stance on the dollar is neutral over the next few months, but bearish for investors with a longer-term horizon. For today, our highest conviction bets are short EUR/JPY and long Swiss franc trades. The US Dollar And Global Growth Chart 2The Dollar Tracks Global Growth There are many important drivers of the US dollar. One is the path for global growth. If global activity is going to slow meaningfully, then as a countercyclical currency, the dollar tends to rise in that environment. The dollar has been closely correlated (inversely) to the trend in global PMIs, industrial production, and other measures of global growth (Chart 2). Across the world, global growth is slowing (Chart 3). Most manufacturing PMIs in the developed world peaked in the middle of last year. In the developing world, China’s zero Covid-19 policy has nudged many PMIs close to the 50 boom/bust level. As a rule of thumb, you do not want to be short the greenback when global industrial activity is slowing. That is the bull case. Chart 3AGlobal Growth Is Slowing In Developed Markets Chart 3BGrowth Is Also Soft In Emerging Markets The good news for dollar bears is that most of this information is already priced in. Looking back at recessions since the 1970s, the dollar is pricing in one of the most anticipated slowdowns in history (Chart 4). This alone is not a reason to turn bearish on the greenback, but it is a red flag towards the consensus view. In general, currencies are a relative game. The dollar tends to rise 10%-to-15% during recessions. We are already there, with the DXY index up 18% since the 2021 lows. It is also important to gauge how the US is faring relative to the rest of the world. Quite simply, US economy economic activity is deteriorating vis-à-vis its trading partners. This is visible in the Citigroup economic surprise indices, but also via a simple chart of relative PMIs (Chart 5). Historically, that has been a negative for the greenback outside of recessions. Chart 4The Dollar Overshoots During Recessions Chart 5US Economic Momentum Is Deteriorating The US Dollar And Interest Rates The Fed hiked interest rates by 75bps this week. This was as expected but given what the Bank of Canada delivered on July 13th, a 100bps hike was a whisper number in our books. More importantly, interest rate differentials (real and nominal) are increasingly moving against the US. As we go to press, 10-year bond yields are 2.67% in the US, but 2.62% in Canada, 3.41% in New Zealand, and even 3.1% in Australia. Chart 6The Euro And Relative Interest Rates The key point is that the market consensus is centered around the Fed being the most hawkish central bank. That will face a critical test in the next few months, if the world enters a recession. This is especially true in the euro area. The market is pricing that interest rates in the eurozone will be 200bps lower next year, relative to the US (Chart 6). The historical spread between US and German 2-year yields has been 83 bps. If Europe indeed enters a deep recession, then that is already priced in the euro. If we get any green shoots in economic growth, then the euro is poised for a coiled-spring rebound. The market is also pricing in that US interest rates will peak next year, relative to other G10 economies (Chart 7). This could happen in one of two ways: The Fed turns more dovish and/or non-US growth loses steam, leading to lower interest rates outside the US. It is difficult to forecast how the economic scenario will evolve, but from an investor’s standpoint, the dollar has already overshot the level implied by relative interest rates (Chart 8). Chart 7US Short Real Yields Are Attractive Chart 8The Dollar Has Overshot Rate Fundamentals A Short Note On USD Valuations Valuations usually get little respect, especially over the last few years. The bull market in the dollar from 2011 to 2022 coincided with higher real interest rates in the US relative to the rest of the developed world. That said, a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Quite simply, rising deficits are a symptom of an overvalued exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar is overvalued on a real effective exchange rate basis (Chart 9 and 10). While valuations tend to matter less until they trigger a tipping point, such inflections usually occur with a shift in animal spirits, especially when investors start to worry about huge external imbalances. Chart 9The Dollar Is Overvalued Chart 10The Dollar Is One Of The Most Expensive Currencies In the US, these imbalances are already starting to spark a shift. The US trade deficit has deteriorated. The basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. It is remarkable that at a time when real rates are quite negative in the US, the dollar is the most overvalued in decades on a simple PPP model basis. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive. According to economic theory, a currency should adjust to equalize returns across countries. In the early 80s, an expensive dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. If global growth shifts from relative strength in the US to overseas, interest rate differentials will tilt in favor of non-US markets. That will be solace for dollar bears. Conclusions In financial markets, it pays to be humble but also to be bold. Our recommended stance on the DXY (and by association, the euro and cable) is to stay on the sidelines. Our highest conviction trade is to short EUR/JPY. With the drop in commodity prices, resource-related currencies are becoming interesting, a topic we will discuss in upcoming bulletins. But momentum is your friend for now, which suggests prudence.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Special Report

Executive Summary Dollar Still The Largest Global Reserve Currency The rise of cryptocurrencies like stablecoins theoretically pose risks to fiat currencies and their general use. In the US, the Federal Reserve will look to adopt a Central Bank Digital Currency (CBDC) – a digital dollar – this decade, to stave off these risks and usher in a new era of central bank money. A digital dollar would likely be integrated as seamlessly as possible into the current monetary regime, thereby maintaining an intermediated role played by existing financial sector actors as well as operating alongside existing circulating currency. The US dollar will eventually face rising competition from digital currencies, both at home and abroad. While other central banks make headway into developing their own CBDCs, China is by far the most advanced. China’s digital yuan will not resolve all of China’s problems with internationalizing its currency but it will create new opportunities. Public and political pushback will occur and will slow adoption of a digital dollar. Gridlock in 2023 may prove to be another headwind. To adopt a digital dollar, politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation, especially as foreign competition on CBDCs rises. Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 10.7% Bottom Line: Policymakers will adopt a CBDC – a digital dollar – this decade. Political pushback may slow adoption, but foreign competition will overcome domestic constraints. Feature Technological innovation over the past decade has given rise to a new asset class – digital assets. Investors are most familiar with cryptocurrencies, and to a lesser extent, non-fungible tokens and decentralized finance-based lending, among others. These assets have witnessed a boom and bust over the past few years (Chart 1). Chart 1Manias: Then And Now Cryptocurrencies have been touted to have money-like characteristics, the most popular being Bitcoin, and others like stablecoins. Stablecoins are mostly used as a medium of exchange between fiat money and cryptocurrencies and vice versa. They are pegged to fiat money and often backed by highly liquid traditional assets1 to maintain their pegs. But cryptocurrencies do not exhibit the traits of durable money today. However, the technological innovation of digital currency represents a natural evolution of money that is irreversible and could someday possess the main characteristics of money: a medium of exchange, a unit of account, and store of value. Cryptocurrencies with money-like qualities theoretically pose a challenge to fiat currencies, i.e. those issued by governments that are not backed by any underlying real asset but rather by trust in government institutions, including the treasury and central bank. Not that trust is a poor basis for a currency. But that trust could fail and new trust could be placed in cryptocurrencies. Governments could eventually lose control of the money supply and payments system, suffer from financial instability, fail to provide regulatory oversight, or fail to prevent the illicit use of digital assets for criminal gain. The same technology driving growth in digital assets has led central banks the world around to research and in some cases develop CBDCs. For an introductory guide to CBDCs, see BCA’s “The Investor’s Guide To Central Bank Digital Currencies.” CBDC research and development are at varying stages across the world’s central banks.2 In the US, the Federal Reserve (Fed) continues to research a CBDC (digital dollar) and its use-case, or justification for being. The Fed has made no commitment to designing a digital dollar anytime soon. But we bet that the Fed’s position will change in coming years. Introducing a digital dollar will reduce the various risks associated with cryptocurrencies whilst also creating efficiencies in the US economy. These efficiencies will also transverse into cross-border efficiencies. Globally, central banks are showing increasing activity in developing CBDCs and introducing a digital dollar would help the Fed maintain monetary dominance across the world while staving off cryptocurrencies, especially stablecoins. The Fed won’t sit idle as a global monetary revolution unfolds. But the policy front is fraught with challenges. Policy makers in the US have expressed mixed views on adopting a digital dollar. Some suggest the Fed would exercise even more control over monetary policy than it does today. Others note risks to consumer data privacy, which could be exploited by government. Public opinion is also mixed with no clear understanding of or need for a digital dollar. Commercial bank business interests may come under attack too, with a digital dollar scalping profit margins from banks, depending on the type and extent of the CBDC operating model employed. Ultimately, the US will want to maintain its position as the global monetary leader. Continued dollar dominance in the global economy is strategically advantageous for the US, especially in a hypo-globalizing world (Chart 2). Ensuring ongoing monetary dominance while rooting out domestic competition from stablecoins will be aided by adopting a digital dollar. Chart 2Dollar Still Dominating Global Reserves Bottom Line: The Fed will most likely adopt a digital dollar within the decade. The Fed And A Digital Dollar The Fed has been actively researching a digital dollar for several years with growing research on design, implementation, and necessity. As it stands, the Fed has not committed to introducing a digital dollar in the foreseeable future. But what would a digital dollar look like and what role would it play in the economy if the Fed decided to introduce one? CBDC Model Briefly, the Fed could choose from three different CBDC operating models: unilateral, synthetic, or intermediated (Diagram 1). A unilateral model would mean the Fed performs all CBDC related functions including direct interaction with end-users. A synthetic model would mean non-Fed actors issuing money backed by Fed assets. Diagram 1Three CBDC Operating Models Realistically, a unilateral and synthetic digital dollar are unlikely. The former would crowd out traditional banking services, while the latter would let actors other than the Fed issue money, violating the Federal Reserve Act. Hence the Fed will most likely pursue an intermediated CBDC model. This model entails digital dollar issuance by the Fed but includes a role for private sector firms to interact with end-users. The intermediary role would be filled by financial firms but also other types of companies such as payment service providers and mobile phone operators. This means the Fed would not totally crowd out existing players across the payment and financial services space. An intermediated model would require the central bank to regulate and oversee other actors, which adds an extra layer of legal and operational complexity to implementation. But it is the model most consistent with the US’s combination of federal government and liberal capitalism, and the model cited by the Fed to most likely be adopted.3 The intermediated model will align with the current two-tier system currently in place (Diagram 2). Digital dollars will feature in both wholesale and retail transactions. Wholesale involves commercial banks and regulated financial intermediaries, while retail involves individuals and non-financial businesses. The model would also operate alongside existing paper money. A digital dollar would be a liability on the Fed, denominated in dollars, and would form an integral part of base money supply (M0). It would be distributed like, and act as a complement to, dollar bills and could be used in transactions conducted in currency and reserves. It would be legal tender just like the paper dollar. Diagram 2Two-Tier Monetary Regime System Digital Dollar Needs The Fed has stated that a digital dollar should, among other things, meet certain criteria before adoption (Table 1). Some of these criteria are already met. Others will be met with adoption. A digital dollar will benefit households, businesses, and the economy at large. For example, a digital dollar would enhance payment transparency, thereby supporting the Fed’s objective to promote safe and efficient payments. And depending on design choices, digital transactions could offer degrees of traceability and aggregate payment data could be analyzed in real time to provide insights into economic health and activity. Table 1Fed Criteria For CBDC Adoption Further, a digital dollar would promote diversification of the payments system, thereby increasing the safety and efficiency of US payment infrastructure. It may also attract new actors offering services related to the digital dollar, spurring financial innovation and fostering financial integration. The payments system is already broadly efficient but adding another layer of digitization with a digital dollar would mean that the US economy would be better positioned for the evolution of the digital economy over the next decade and beyond. The need for broad stakeholder support will be a difficult criterion to meet, however. There would need to be more engagement with the public, inter-government agencies, and Congress. For now, these “needs” outlined by the Fed are more than half met, signaling that a digital dollar could come to fruition within the decade from a policy perspective. International advances on this front will spur US policy makers into action even if they are disinclined. Bottom Line: The needs outlined by the Fed to adopt a digital dollar have been mostly met which ticks off one of the policy implementation checkboxes. There are gains to be had across the economy by introducing a digital dollar, ranging from a more efficient payments system to financial inclusion and decreasing transactions costs. Domestic Competition The proliferation of stablecoins has been noted by government agencies around the world. The Fed too has been keeping note. By the end of 2021, stablecoins had a relatively small market capitalization compared to the broader cryptocurrency market, approximately 6%. Now, stablecoins account for almost 16% of cryptocurrency market capitalization. But trading volumes point to stablecoins having a much larger role in transactions (Chart 3). Stablecoins resolve some of the problems of faith and trust that bedevil cryptocurrencies not backed by traditional assets. Chart 3Stablecoins Rise In Popularity Stablecoins pose two key threats that a digital dollar will essentially nullify: Systemic risk: A growing stablecoin market that is increasingly backed by traditional, high liquid assets could create systemic risk in traditional asset markets. An excessive rise or fall in demand for stablecoins would cause volatility in the liquid assets that back them. Moreover, for example, a fire sale in the stablecoin market would cause demand to fall excessively relative to the backing asset. Prices between stablecoins and the backing asset would diverge, potentially breaking the peg and resulting in further price divergence. And more broadly, high volatility from crypto markets can penetrate traditional or risk-free markets. A digital dollar would render stablecoins unnecessary, allowing cryptocurrency users to transact and convert digital dollars to cryptocurrency while enjoying the backing of the Fed on the value of digital dollars. Cross-border transactions: Stablecoins are also increasingly used for cross-border transactions. According to Fed data, the US pays 5.4% in fees on average per cross-border transaction, which also takes several days to settle. Stablecoins settle almost instantaneously and have much lower transaction fees. So too can a digital dollar. It would settle just as quickly as a stablecoin, if not quicker, and reduce transaction costs for cross-border payments. And because stablecoins are designed to maintain their pegs, they have more potential than cryptocurrencies to act as mediums of exchange outside of the crypto market and economy, potentially threatening the ongoing use of fiat money. Bottom Line: The Fed will design a CBDC around its existing monetary and payments system to allow for seamless integration. There are not many reasons holding back digital dollar adoption from a point of need and benefit. By adopting a digital dollar, the Fed will also fight off the growing risk of stablecoins, which could pose a threat to the use-case of fiat money in everyday life. Other Central Banks On The March The authority to issue money is an important element of economic power. History is replete with examples of currency competition both within countries and between them. CBDC research and development are picking up speed across central banks (Charts 4A and 4B). China is the world leader with its digital yuan, as we discuss below. Design and implementation of CBDCs will follow in coming years just like in the case of the digital yuan. If the theoretical payoffs to adopting a CBDC are met by real-world green shoots, then foreign CBDCs could pose a threat to continued dollar dominance in the global monetary and economic system, namely if countries can draw down their dependence on dollar reserves. Chart 4ACentral Banks Paying More Attention To CBDCs Chart 4BCentral Banks Paying More Attention To CBDCs Central Bank Competition Treasury Secretary Janet Yellen has noted this challenge in recent remarks explaining that any implementation of a “US central bank digital currency must support the prominent role the dollar plays in the global financial system.”4 The Fed is on the same page as the Treasury noting that any CBDC should be used to preserve the dominant international role of the dollar. The dollar is the world’s most widely used currency for payments and investments and serves as the world’s premier reserve currency. The dollar’s international role allows the US to influence the practices and standards of the global monetary and economic system. Basically, when the US constricts the supply of dollars in response to domestic conditions, the rest of the world suffers tighter monetary conditions, and when the US expands the supply, the rest of the world enjoys looser conditions, almost regardless of what other nations want or need. Central banks have made their policy goals clear in respect to developing a CBDC. Some central banks look to expand financial inclusion, market access, and their payments system while others are looking to compete with one another (Table 2). Canada, China, and Sweden want to gain a local and international market advantage for their currencies by introducing CBDCs. Table 2CBDC Policy Goals Of Central Banks China Leading CBDC Race, But… At this early stage, China’s digital yuan poses the largest threat to a digital dollar on the international stage. It is the most prominent CBDC project at this current juncture. The digital yuan entered beta testing at the end of 2020 in parts of the country. Wider testing across provinces is being phased in. China’s monetary endeavors began with the Cross-Border Inter-Bank Payment Service in 2015. The digital yuan will be positioned as an extension of this system to promote the national currency and fight global dollar dominance. But how big of a challenge could a digital yuan mount? The answer is not much, not now. China is the world’s largest trading partner but the renminbi accounts for less than 3% of the world’s reserve currency (Chart 5). The disparity between trade and currency status in the global economy reflects a lack of global trust in the renminbi and is a cause for concern for China. China is structurally invested in the dollar-dominated financial system and hence vulnerable to American influence by means of that system. Chart 5Global Renminbi Reserves Are Low The digital yuan would support more debt issuance based on cost and payment incentives to debt holders when financing BRI projects. This will help drive the use of the digital yuan going forward. For example, China can assert its influence over countries with Chinese debt by having them accumulate digital yuan reserves to pay back loans. China can even provide countries with concessions on loans to promote its digital yuan. Concessions on Chinese debt may lead to easier uptake, therefore promoting issuance. If the cost of switching to the digital yuan is low, countries will see no benefit in continuing their trade transactions with China in US dollars. Using the digital yuan as the currency of invoice to disburse loans can make these transactions more transparent and manageable. This could also allow for more state control over funds, an attractive scenario for China. However, China’s monetary ambitions face serious constraints. Lack of trust in the currency is the most critical challenge for internationalization of the yuan, digital or otherwise. Even if the digital yuan project is five to ten years ahead of the curve, countries still opt to hold the dollar over the yuan in any type of crisis, as has been amply demonstrated in history, and over a range of global shocks since 2019. Hence digital yuan adoption will require guarantees from Chinese institutions. But these same institutions have struggled to internationalize the paper renminbi. Lack of openness, transparency, and convertibility are persistent problems. Bottom Line: Central banks around the world are gearing up to introduce CBDCs in coming years. Some are looking to promote financial inclusivity. Others like China’s digital yuan want to chip away at the dollar’s global dominance. Digital versions of fiat currencies will have to demonstrate substantial economic and trade efficiencies in order to encourage diversification away from the US dollar, since there is no inherent reason a digital version of a nation’s currency would increase trust beyond what is already established. But those efficiencies could take shape, which would put pressure on the US to respond. The US faces significant monetary challenges over the long run, including from CBDCs. But the US is a technological power and will eventually respond by developing its own CBDC. Pushback Against A Digital Dollar The Fed has stated that it would only pursue a digital dollar in the context of broad public and cross-governmental support. However, neither the public nor congress broadly support one at present. Public opinion is uneducated on the issue and therefore highly malleable depending on leadership and events. Public Opinion Is Non-Supportive Across age groups, people do not know enough about digital currencies and think it is a bad idea to introduce a digital dollar (Chart 6). A 2020 poll found that only 13% of respondents approved of a digital dollar.5 Low approval is becoming a trend. However, the same poll showed that 38% of respondents think the US dollar is backed by gold, bonds, or oil. Addressing poor monetary literacy among the public would help to improve public support of a digital dollar. US households say they are more likely to trust traditional financial institutions than government agencies to safeguard their personal data (Chart 7). A digital dollar will grant the Fed and federal government far-reaching information regarding the everyday financial transactions of households. Trust in government has been declining and a digital dollar underpinned by a central ledger system would provoke consumer privacy lobby groups and government activists to fight and protest adoption (Chart 8). Chart 6Popular Support For A Digital Dollar Is Lacking Chart 7Households Trust Government Less Than Financial Institutions Chart 8Trust In Government Has Been Waning Chart 9Inflation Outbreak Will Limit Big Government About half of the US public already view the government as “doing too much” (Chart 9). The explosive inflation of 2020-22 will slow the underlying ideological shift to the political left, potentially limiting support for a digital dollar. Public opinion has been shifting for decades in favor of more government involvement in people’s day-to-day lives (Chart 10), but that trend may well stall now that excess of government creates tangible negatives for household pocketbooks (inflation). The bigger of a problem the Fed has in taming inflation in 2022-23, the bigger the political backlash will be. Federal solutions will suffer as a result. This is our theme of “Limited Big Government,” since the role of the state will increase relative to the past 40 years but still within an American context of checks and balances. Chart 10People Have Favored Government Involvement Bottom Line: There is no clear public demand for the digitization of the dollar at present. A major financial or economic disruption stemming from the monetary system or digital assets may be necessary to call public attention to the question. Meanwhile the private sector will drive innovation and the federal government will react to try to maintain domestic stability and international competitiveness. These data support the Fed taking an intermediated approach to cbdc when forced to take action. Policymakers Will Resist Policymakers are divided over the idea of a digital dollar. Senator Ted Cruz introduced a bill in March 2022 to “prohibit the Federal Reserve from offering products or services directly to individuals, maintaining accounts on behalf of individuals, or issuing a central bank digital currency directly to an individual.”6 Cruz has yet to receive widespread party support on the bill but he could get the backing from more GOP members if Republicans take over Congress, as expected, this November. Some Republicans and Democrats have favored cryptocurrencies while others have not, advocating for crypto-mining and crypto start-ups in progressive-left and libertarian right states. But the center-left and center-right might lean more toward cryptocurrency regulation and digital dollar adoption. Coalitions may need to be formed on the topic of a digital dollar, in parties and between parties. A digital dollar will cause a level of disruption, which will affect both the Democrats and Republicans. Government gridlock will create challenges to digital dollar adoption too. The upcoming mid-term elections favor the GOP. Both the House and the Senate are expected to flip in favor of the GOP in 2023. The “Blue Sweep” policy setting will end and only the White House will remain in Democrat control. Republicans have a shot at flipping the White House in 2024, which could see a “Red Sweep.” This scenario may slow adoption of a digital dollar but it will only preclude the unilateral cbdc model, not the intermediated model. The period of 2023-24 is too soon for adoption of a digital dollar anyway but the fact is that gridlock will delay the process until external factors force US action. Bottom Line: Public and political pushback will slow the adoption of a digital dollar. Politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation but this will be difficult in a highly polarized country and will likely depend on foreign competition. Investment Takeaways We avoided cryptocurrencies during the irrational exuberance over the past two years. We expect governments to regulate the sector in order to preserve a monopoly over money supply and hence geopolitical interests. With monetary conditions tightening, we expect continued volatility in the crypto space. The US dollar remains strong tactically but is nearing its peak cyclically. We remain long but have put the currency on downgrade watch as the market more fully prices a range of bad news this year. On the global stage, the US dollar will remain the premier reserve currency despite cyclical ups and downs. The current macroeconomic backdrop is negative for the US financial sector (Chart 11). Mergers and acquisitions are drying up while regulatory risks loom. Initial public offerings are also slowing, while trading volume is low. Consumers had already accumulated debt earlier in the cycle and with rising interest rates amid a more challenging job environment, growth in loans and ultimately bank profits will slow. The commercial banking sector faces challenges during the upcoming transitional period of disruptive innovation and regulatory uncertainty. We believe the Fed and policymakers in general will want to cause as little disruption as possible, by integrating any digital dollar with the traditional finance sector as seamlessly as possible. However, transitions, especially those digital in nature, bring with them high uncertainty in the financial sector and elsewhere. Chart 11Financial Sector Facing Macro Headwinds     Guy Russell Senior Analyst guyr@bcaresearch.com     Footnotes 1     Stablecoins are backed by various assets and means. Fiat money, commodities, other cryptocurrencies and by algorithmic means are some examples. 2     See The Bank For International Settlements, Central Bank Digital Currencies: Executive Summary, September 2021, bis.org. 3    See The Board of Governors of the Federal Reserve System, Money and Payments: The U.S.Dollar in the Age of Digital Transformation, January 2022, federalreserve.gov. 4    See U.S. Department Of The Treasury, Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets, April 2022, treasury.gov. 5    See Cointelegraph, Most Americans are against a digital dollar CBDC, survey reveals,september 25, 2020, cointelegraph.com 6    See Ted Cruz’s Proposed Bill to amend the Federal Reserve Act to prohibit the Federal reserve banks from offering certain products or services directly to an individual, and for other purposes, March 2022, cruz.senate.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets