Europe

Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal.  The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong Chart 2More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Chart 4Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 8Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave Chart 11Rate Differentials Hurt The Euro   Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Chart 18Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades   Currency Performance Fixed Income Performance Equity Performance

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 18US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 22Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 25Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Despite strong economic activity throughout most of 2021, economic surprises have decreased considerably. This helped the US equity market outperform Europe. It also significantly contributed to the euro’s depreciation versus the dollar. Even though growth will slow in 2022, economic surprises should increase. Growth expectations are much lower than they were entering 2021, and some key headwinds will fade. This picture is not without risks. China’s credit slowdown and the US’s elevated inflation represent the greatest threats. Based on the outlook for economic surprises, the euro will stage a rebound next year and small-cap stocks are attractive. Feature Global economic activity has been exceptionally robust this year, boosted by the re-opening of the world economy, as well as by the considerable fiscal and monetary stimuli injected globally over the past 20 months. However, market participants also anticipated such a rebound; as a result, global economic surprises peaked in September 2020, and they are now in negative territory. Unanticipated developments have a substantial effect on market prices. Under this lens, the deterioration in economic surprises has had a strong impact on financial markets. It helps explain why the defensive US market has outperformed, why the dollar has been strong, and why bond yields have been flat since March 2021, even though inflation has risen, growth has been high by historical standards, and many major central banks have been eschewing their accommodative biases. Going forward, the evolution of economic surprises will remain crucial to market trends. While we anticipate global economic activity will decelerate in 2022, it will likely remain above trend and surprise to the upside, which will allow global economic surprises to recover. There are significant risks to this view, with large unanswered questions about the Chinese economy and the outlook for inflation in the US. In this context, despite near-term risks, we continue to expect EUR/USD to appreciate in 2022 and European small-cap stocks to outperform large-cap equities. Deteriorating Surprises Matter This year, the underperformance of global equities (both EM and Europe) relative to the US, the weakness in the euro, and the limited increase in yields have all caught investors off guard. At the beginning of 2021, investors were massively short the greenback and duration, while surveys showed a large preference for non-US equities. These views grew out of the expectation that global growth would be strong. Global growth turned out to be strong but began to disappoint expectations by the middle of the year. Expectations had become extremely lofty, suggesting that the bar had been set too high. Additionally, the tightening credit conditions in China and the growing supply constraints around the world caused growth to decelerate somewhat. The deterioration in short-term economic momentum and in surprises harmed European equities relative to the US. As Chart 1 highlights, the relative performance of European stocks is greatly affected by the earnings revision ratio of cyclicals stocks vis-à-vis defensive ones. This relationship reflects the greater pro-cyclicality of European equities compared to those of the US. Moreover, the earnings revision ratio of cyclical stocks relative to that of defensive equities mimics the fluctuations in economic surprises (Chart 1, bottom panel), as weaker-than-expected growth invites analysts to lower their relative earning expectations. The dynamics in the economic surprise index also weighed heavily on the FX market. The dollar is a highly counter-cyclical currency; therefore, it performs poorly when growth is not only increasing, but also doing so at a rate faster than anticipated. However, economic surprises did the exact opposite this year, which boosted the dollar’s appeal and pushed EUR/USD lower (Chart 2). While the strength in the dollar was accentuated by the increasingly aggressive pricing of Fed hikes in the OIS curve, relative interest rate expectations between the US and the Euro Area are also influenced by global economic activity because of the European economy’s greater cyclicality than that of the US. Chart 1Where Surprises Go, European Stocks Follow Chart 2Surprises Matter For The Dollar And The Euro Bottom Line: Global growth has been very strong in 2021, but it has begun to decelerate. Moreover, economic surprises are now in negative territory. The evolution of economic surprises this year was a key component of the strength in the dollar, the weakness of the euro, and the underperformance of European equities. Improving Surprises In 2022? We anticipate economic surprises to pick up in 2022. First, investors and analysts around the world rightfully expect a slowdown in global growth next year. This means that the bar for the economy to generate positive surprises is lower than it was in 2021. Second, we are already seeing signs that global economic surprises are trying to stabilize. A GDP-weighted aggregate of 48 countries is forming a trough at a low level, which historically precedes a pick-up in broader aggregate measures (Chart 3). Third, economic surprises move closely with the global PMI diffusion index. The diffusion index has fallen to levels historically associated with a rebound (Chart 4). Moreover, the share of countries whose Leading Economic Indicator is rising is still very depressed for a mid-cycle slowdown (Chart 4, bottom panel). As vaccination rates are improving around the world, including those in emerging markets, and as the global economy continues to re-open, we anticipate both the PMI and LEI diffusion indexes to improve next year, which will boost economic surprises. Chart 3A Budding Rebound? Chart 4The dispersion Of Growth Matters or Surprises Fourth, the global capex outlook remains very positive. Capex intentions in the US and in the Euro Area are highly elevated and cash flows are strengthening. Moreover, US and European credit standards are very loose (Chart 5). This combination suggests that companies have the desire and the wherewithal to increase their investments next year, especially as capacity constraints limit their ability to meet final demand. Additionally, companies around the world need to rebuild inventory levels, which are depressed relative to sales, while customer inventories are still woefully low (Chart 6). Chart 5Capex Tailwinds Chart 6Not Enough Inventories Chart 7Households Are Rich Fifth, households globally also have ample firepower to support their spending, despite some weakness in real income caused by rising inflation. As Chart 7 shows, household net worth in the US is up by 128% of GDP since December 2019. Additionally, the accumulated stocks of household excess savings have reached USD2.4 trillion in the US, EUR150 billion in German, EUR130 billion in France and GBP180 billion in the UK. With respect to the Eurozone specifically, fiscal and monetary policy will remain very accommodative. The fiscal thrust in 2022 will be negative 2.1%, which is significantly less onerous than the US’s -5.9% of GDP. Moreover, economies like Italy and Spain may have a negligible fiscal thrust because of the NGEU program’s disbursements. In addition, while the fiscal thrust will be slightly negative next year, government deficits will remain wide, which indicates that fiscal policy in Europe continues to support demand. Meanwhile, monetary policy still generates deeply negative interest rates on the continent, which sustains demand further. This view is not without risks. The first threat stems from the Chinese credit slowdown. BCA’s China strategists expect credit flows to bottom out by the second quarter of 2022, which implies that Chinese domestic activity should accelerate meaningfully in the second half of the year.  Already, we are seeing tentative signs that authorities in China are trying to curb the credit slowdown. For example, Beijing cut the reserve requirement ratio last summer and excess reserves in the banking system are moving back up as liquidity injections grow (Chart 8). The problem is that, so far, Chinese credit demand is not responding to these small measures designed to ease policy. More will be needed as the tightening in financial conditions for real estate developers points to significant downside ahead in construction activity (Chart 9). For now, it is difficult for Beijing to ease policy much more than it has done so far: PPI has reached a 25-year high at 13.5%. Chart 8Not Enough... Chart 9... Especially With Such A Drag These Chinese inflationary pressures are likely to decline in the first months of 2022, which will allow Beijing to become more aggressive in its support to economic activity. First, Chinese demand is weak, unlike demand in the US. Second, the surge in the PPI is mostly driven by a 17% increase in the energy PPI and a 66% surge in the mining component. These jumps are unlikely to repeat themselves, which will reduce overall inflationary numbers in that economy. The second major risk is global inflation, which is hurting real wages. As a case in point, US real wages are contracting at a 3.2% annual rate, or their deepest cut in six decades. In Europe too, real wages are weak because of the increase in inflation. While these inflationary pressures have had limited effect on European consumer confidence so far, US consumer confidence is breaking down (Chart 10), driven by a collapse in the willingness to buy. If this trend continues, we might see a significant deceleration in global real consumer spending. Chart 10Not All Is Dark On The Inflation Front We still expect the European inflationary risk to start dissipating in the first half of 2022. Unlike in the US, the spike in core CPI mostly reflects an increase in VAT and remains narrow, with trimmed-mean CPI lingering near record lows. Moreover, the 24-month rate of change of core CPI remains within the historical norm, which is not the case in the US. The US situation is more tenuous. Last week’s inflation data showed a broadening of inflationary pressures across major sectors of the economy unaffected by the pandemic, with shelter inflation being of particular concern. However, there are positives. Long-term inflation expectations, as approximated by the 5-year/5-year forward inflation breakeven rate, are still below the levels that prevailed before the oil price crash of 2014 (Chart 11, top panel). Additionally, shipping costs have started to ebb, with global container freight rates losing steam and the Baltic Dry index collapsing by 50% since beginning of October (Chart 11, bottom panel). Moreover, as health restrictions are being relaxed in Asia, Asian PMI’s are improving, while the production of semiconductors is rising again in the region (Chart 12). As a result, although there is still significant inflation risk over the next five years, 2022 is likely to witness a temporary pullback in CPI growth. Chart 11Not All Is Dark On The Inflation Front Chart 12Semiconductor Production Is Picking Up Bottom Line: Global investors are right to anticipate a decline in global growth next year. However, even if growth slows, it will remain above trend. Moreover, the considerable stimuli in the global economy and the decreased expectations of investors improve the odds that global economic surprises will increase in 2022. China’s domestic weakness and the rise in US inflation constitute the two greatest risks to this view. Investment Implications The level of the global economic surprise index as well as its evolution have important implications for many key European assets. Table 1 highlights the performance of various financial markets at three months, six months, and a year following various ranges of readings of the surprise index (the categories are based on one standard-deviation intervals from the mean). We highlight this methodology, because there remains significant uncertainty about the near-term outlook of the surprise index. Table 1Level Of Surprises And Subsequent Returns Currently, the global economic surprise index stands at -20, or between its -1-sigma and its historical average. This level offers limited clear results for investors when it comes to the performance of the Eurozone benchmark relative to the MSCI All Country World Index (ACWI), and no clear results in terms of the performance of value stocks relative to growth. However, the current reading of the surprise index is consistent with an outperformance of growth stocks relative to momentum over both the three- and six-month horizons. It is also showing a 74% probability of small-cap equities beating large-cap ones over a 12-month basis. Table 2 shows the performance of the same assets over the same windows, following three consecutive months or more of an improving global economic surprise index. This is consistent with our main hypothesis that global economic surprises are set to increase by early next year. Table 2Surprise Upticks And Subsequent Returns Using this method again shows no strong call for the Euro Area equity benchmark relative to the ACWI. There is a small improvement in performance, but Europe on average still underperforms, which reflects the thirteen years of a relative bear market in European equities. Similarly, results for European value stocks compared to growth equities are limited, as the sample is dominated by the structurally poor performance of value equities. However, this method highlights that the euro is likely to appreciate against the USD on both the three- and six-month investment horizon. This message is consistent with that of our Intermediate-Term Timing Model. Finally, this approach once again underscores the attractiveness of European small-cap equities on a three-, six-, and twelve-month investment horizon. Consequently, we maintain our buy recommendation on the euro. As we wrote three weeks ago, the near-term outlook for the common currency is fraught with risks and the low readings of the global economic surprise index confirm this reality.  Moreover, markets might enter a phase when they aggressively discount Fed rates hikes next year, which would further hurt the euro. However, the outlook for global growth will ultimately put a floor under EUR/USD. Chart 13Small-Caps: Almost There We also view European small-cap stocks as the premier equity vehicle in Europe over the coming 18 months because of their heightened pro-cyclicality.  However, the timing around shifting toward overweighing small-cap remains risky in the near-term, as they have not fully worked out the overbought conditions we flagged four weeks ago (Chart 13). Thus, we maintain small-cap equities on an upgrade alert, and we are looking to pull the trigger very soon.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance