Europe

Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary   Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Chart 1Wave Dynamics Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet Chart 2The Economy Is Not Out Of The Woods Yet The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later.  It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB Chart 3A Careful ECB This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro Chart 4A Murky Outlook For The Euro Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities Chart 5German Yields Are Key To Value Stocks And Italian Equities Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Chart 6Europe’s Quality Deficit Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Chart 7Will The Cyclicals Outperformance Resume? The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Chart 8Favor Financials These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Chart 9Small-Caps Are Nearly There Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round.   Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022,  and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years.  Chart 9Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Special Report

Highlights The last two years have taught us to live with Covid-19. This means global growth will remain strong in 2022. That is not reflected in a strong dollar. The RMB will be a key arbiter between a bullish and bearish dollar view. This is because a weak RMB will be deflationary for many commodity currencies, especially if it reflects weak Chinese demand. Inflation in the US will remain stronger than in other countries. The key question is what the Federal Reserve does next year. In our view, they will stay patient which will keep real interest rates in the US very low. Upside in the DXY is nearing exhaustion according to most of our technical indicators. We upgraded our near-term target to 98. Over a longer horizon, we believe the DXY will break below 90, towards 85 in the next 12-18 months. A key theme for 2022 will be central bank convergence. Either inflation proves sticky and dovish central banks turn a tad more hawkish, or inflation subsides and aggressive rate hikes priced in some G10 OIS curves are revised a tad lower. The path for bond yields will naturally be critical. Lower bond yields will initially favor defensive currencies such as the DXY, CHF and JPY. This is appropriate positioning in the near-term. Further out in 2022, as bond yields rise, the Scandinavian currencies will be winners. Portfolio flows into US equities have been a key driver of the dollar rally. This has been because of the outperformance of technology. Should this change, equity flows could switch from friend to foe for the dollar. A green technology revolution is underway and this will benefit the currencies of countries that will supply these raw materials. The AUD could be a star in 2022 and beyond. The rise in cryptocurrencies will continue to face a natural gravitational pull from policy makers.    Gold and silver will rise in 2022, but silver will outperform gold. Feature 2022 has spooky echoes of 2020. In December 2019, we were optimistic about the global growth outlook, positive on risk assets, and bearish the US dollar. That view was torpedoed in March 2020, when it became widely apparent that COVID-19 was a truly global epidemic. More specifically, the dollar DXY index (a proxy for safe-haven demand) rose to a high of 103. US Treasury yields fell to a low of 0.5%. Chart 1Covid-19 And The Dollar Today, the DXY index is sitting at 96, exactly the midpoint of the March 2020 highs and the January 2021 lows. Once again, the dollar is discounting that the new Omicron strain will be malignant – worse than the Delta variant, but not as catastrophic as the original outbreak (Chart 1). Going into 2022, we are cautiously optimistic. First, we have two years of data on the virus and are learning to live with it. This suggests the panic of March 2020 will not be repeated. Second, policymakers are likely to stay very accommodative in the face of another exogenous shock. This will especially be the case for the Fed. Our near-term target for the DXY index is 98, given that the macro landscape remains fraught with risks. This is a speculative level based on exhaustion from our technical indicators (the dollar is overbought) and valuation models (the dollar is expensive). Beyond this level, if our scenario analysis plays out as expected, we believe the DXY index will break below 90 in 2022. Omicron And The Global Growth Picture Chart 2Global Growth And The Dollar Our golden rule for trading the dollar is simple – sell the dollar if global growth will remain robust, and US growth will underperform its G10 counterparts. Historically, this rule has worked like clockwork. Using Bloomberg consensus growth estimates for 2022, US growth is slated to stay strong, but give way to other economies (Chart 2).  News on the Omicron variant continues to be fluid. As we go to press, Pfizer suggests a third booster dose of its vaccine results in a 25-fold increase in the antibodies that attack the virus. Additionally, a new vaccine to combat the Omicron variant will be available by March. If this proves accurate, it suggests the world population essentially has protection against this new strain. The good news is that vaccinations are ramping up around the world, especially in emerging markets. Countries like the US and the UK were the first countries to see a majority of their population vaccinated. Now many developed and emerging market countries have a higher share of their population vaccinated compared to the US (Chart 3). Chart 3ARising Vaccinations Outside The US Chart 3BRising Vaccinations Outside The US This has resulted in a subtle shift – growth estimates for 2022 are increasingly favoring other countries relative to the US (Chart 4). Let us consider the case of Japan - just in June this year, ahead of the Olympics, only 25% of the population was vaccinated. Today, Japan has vaccinated 77% of its population and new daily infections are near record lows. While Omicron is a viable risk, the starting point for Japan is very encouraging and should open a window for a recovery in pent-up demand and a pickup in animal spirits. Chart 4ARising Growth Momentum Outside The US This template could very much apply to other countries as well. This view is not embedded in the dollar, which continues to price in an outperformance of US growth (Chart 5). The Risks From A China Slowdown China sits at the epicenter of a bullish and bearish dollar view. If Chinese growth is bottoming, then the historical relationship between the credit impulse and pro-cyclical currencies will hold (Chart 6). This will benefit the EUR, the AUD, the CAD and even the SEK which that track the Chinese credit impulse in real time. As an expression of this view, we went long the AUD at 70 cents. Chart 5Economic Surprises Outside The US Chart 6Chinese Credit Demand And Currencies Just as global policy makers are calibrating the risk from the Omicron variant, the Chinese authorities are also acknowledging the risk of an avalanche from a property slowdown. They have already eased monetary policy on this basis. Specific to the dollar, a key arbiter of a bullish or bearish view will be the Chinese RMB. So far, markets have judiciously separated the risk, judging that the Chinese authorities can surgically diffuse the real estate market, without broad-based repercussions in other parts of the economy (such as the export sector). Equities and corporate credit prices have collapsed in specific segments of the Chinese market but the RMB remains strong (Chart 7). Correspondingly, inflows into China remain very robust, a testament to the fact that Chinese growth (while slowing) remains well above that of many other countries (Chart 8). Chart 7The RMB Has Diverged From The Carnage In China Chart 8Strong Portfolio Inflows Into China China contributed 20% to global GDP in 2021 and will likely contribute a bigger share in 2022, according to the IMF (Chart 9). This suggests that foreign direct investment in China will remain strong . This will occur at a time when the authorities could have diffused the risk from a property market slowdown. The commodity-side of the equation will also be important to monitor, especially as it correlates strongly with developed-market commodity currencies. It is remarkable that despite the slowdown in Chinese real estate, commodity prices remain resilient (Chart 10). This has been due to adjustment on the supply side, as our colleagues in the Commodity & Energy Strategy team have been writing. Finally, China offers one of the best real rates in major economies. It also runs a current account surplus. This suggests there is natural demand and support for the RMB (Chart 11). A strong RMB limits how low developed-market commodity currencies can fall. Chart 10Commodity Prices Remain Well Bid Chart 11Real Interest Rates Favor The RMB Inflation And The Policy Response Output gaps are closing around the world as fiscal stimulus has helped plug the gap in aggregate demand. This suggests that while inflation has been boosted by idiosyncratic factors (supply bottlenecks) that could soon be resolved, rising aggregate demand will start to pose a serious problem to the inflation mandate of many central banks. Chart 12A Key Driver Of The Dollar Rally As we wrote a few weeks ago, there have been consistencies and contradictions with the market response to higher inflation. The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year. Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent) (Chart 12). The reality is that outside the ECB and the BoJ, other central banks have actually been more proactive compared to the Federal Reserve. The Bank Of Canada has ended QE and will likely raise interest rates early next year, the Reserve Bank of New Zealand has ended QE and raised rates twice, and the Reserve Bank of Australia has already been tapering asset purchases. The Bank of England will also be ahead of the Fed in raising interest rates, according to our Global Fixed Income Strategy colleagues. This suggests that the pricing of a policy divergence between the Fed and other G10 central banks could be a miscalculation and a potential source of weakness for the dollar. Chart 13The US Is Generating Genuine Inflation Rising inflation is a global phenomenon and not specific to the US (Chart 13). So either inflation subsides and the Fed turns a tad more accommodative, or inflation proves sticky and other central banks turn a tad more hawkish to defend their policy mandates. We have two key short-term trades penned on this view – long EUR/GBP and long AUD/NZD. While the European Central Bank will lag the Bank of England (and the Fed) in raising interest rates, expectations for the path of policy are too hawkish in the UK, with 4 rate hikes priced in by the end of 2022. Similarly, hawkish expectations for the Reserve Bank of New Zealand are likely to be revised lower, relative to the Reserve Bank of Australia. As for the US, the Fed is likely to hike interest rates next year but real rates will remain very low relative to history (Chart 14A and 14B). Low real rates will curb the appeal of US Treasuries. Chart 14AReal Interest Rates In The US Are Very Negative The Dollar And The Equity Market Chart 15The US Stock Market And The Dollar One of the biggest drivers of a strong dollar this year (aside from rising interest rate expectations), has been equity inflows. The greenback tends to do well when US bourses are outperforming their overseas peers (Chart 15). It is also the case that value tends to underperform growth in an environment where the dollar is rising. We discussed this topic in depth in our special report last summer. Flows tend to gravitate to capital markets with the highest expected returns. So if investors expect the pandemic winners (technology and healthcare) to keep driving the market in an Omicron setting, the US bourses that are overweight these sectors will do well. We will err on the other side of this trade for 2022. Part of that is based on our analysis of the global growth picture in the first section of this report. If growth rotates from the US to other economies, their bourses should do well as profits in these economies recover. Earnings revisions in the US have been sharply revised lower compared to other countries (Chart 16). This has usually led to a lower dollar eventually. In the case of the euro area, there has been a strong and consistent relationship between relative earnings revisions vis-à-vis the US, and the performance of the euro (Chart 17). Chart 16Earnings Revisions Are Moving Against US Companies Chart 17Earnings Revisions Are Moving In Favor Of Euro Area Companies In a nutshell, should profits in cyclical sectors recover on the back of rising bond yields, strong commodity prices and a tentative bottoming in the Chinese economy, value sectors that are heavily concentrated in countries with more cyclical currencies such as Australia, Norway, Sweden, and Canada, will benefit. Ditto for their currencies. The Outlook For Petrocurrencies When the pandemic first hit in 2020, oil prices (specifically the Western Texas Intermediate blend) went negative. This drop pushed the Canadian dollar towards 68 cents and USD/NOK punched above 12. This time around, the drop in oil prices (20% from the peak for the Brent blend) has been more muted. We think this sanguine market reaction is more appropiate in our view for two key reasons. First, as our colleagues in the Commodity & Energy Stategy team have highlighted, investment in the resource sector, specifically oil and gas, has been anemic in recent years. In Canada, investment in the oil and gas sector has dropped 68% since 2014 at the same time as energy companies are becoming more and more compliant vis-à-vis climate change (Chart 18). Second, if we are right, and Omicron proves to be a red herring, then transportation demand (the biggest source of oil demand) will keep recovering. In terms of currencies, our preference is to be long a petrocurrency basket relative to oil consumers. As the US is the biggest oil producer in the world (Chart 19), being long petrocurriences versus the dollar has diverged from its historical positive relationship with oil prices. Chart 20 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with oil prices and has outperformed a traditional petrocurrency basket. Chart 19The US Is Now A Major Oil Producer Chart 20Hold A Basket Of Oil Consumers Versus Producers Technical And Valuation Indicators The dollar tends to be a momentum-driven currency. Past strength begets further strength. We modelled this when we published our FX Trading Model, which showed that a momentum strategy outperformed over time (Chart 21).  The problem with momentum is that it works until it does not. Net speculative long positions in the dollar are approaching levels that have historically signaled exhaustion (Chart 22). There is a dearth of dollar bears in today’s environment. That is positive from a contrarian standpoint. Meanwhile, our capitulation index (a measure of how overbought or oversold the dollar is) is approaching peak levels. Chart 21The Dollar Is A Momentum Currency Chart 22Long Dollar Is A Consensus Trade Valuation is another headwind for the dollar. According to all of our in-house models, the dollar is expensive. That is the case according to both our in-house curated PPP model (Chart 23) and a simple one based on headline consumer prices (Chart 24). Chart 24The Dollar is Expensive     In a broader sense, we have built an attractiveness ranking for currencies (Chart 25). This ranks G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone and Swedish krona are especially attractive as 2022 plays. More specifically, the Scandinavian currencies have been one of the hardest hit this year. The Norwegian krone will benefit from the reopening of economies, particularly through the rising terms-of-trade. The Swedish krona will benefit from a pickup in the industrial sector, and continued strength in global trade. The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. As we have highlighted in previous reports, valuation is a poor timing tool in the short term but over a longer-term horizon, currencies tend to revert towards fair value. Where Next For EUR/USD? Our bias is that the euro has bottomed. The ECB will lag the Fed in raising interest rates, but the spread between German bund yields and US Treasuries does not justify the current level of the euro. More importantly, if European growth recovers next year, this will sustain portfolio flows into the eurozone, which are cratering (Chart 26). Our 2022 target for EUR/USD is 1.25, a level that will unwind 10.6% of the undervaluation versus the dollar. Beyond valuation,s a few key factors support the euro: As a pioneer in green energy and a pro-cyclical currency, the euro will benefit from portfolio flows into renewable energy companies, as well as foreign direct investment. A close proxy for these flows are copper prices, that have positively diverged from the performance of the euro (Chart 27). Chart 26The Euro And Portfolio Flows Chart 27EUR/USD And Copper ​​​​​ Inflation in the euro area is lagging the US, but is undeniably strong. As such, while the ECB will lag the Fed in tightening monetary policy, the divergence in monetary policy will not widen. Earnings revisions are moving in favor of European companies, as we have shown earlier. Historically, this has put a floor under the euro. Safe-Haven Demand: Long JPY Safe-haven currencies will perform well in the near term. We are long the yen, which is the cheapest currency according to our models and also one of the most shorted. CHF will also do well in the near term, though as we have argued, will induce more intervention from the Swiss National Bank. We are long both the yen and CHF/NZD as short-term trades, but our preference is for the yen. First, Japan has one of the highest real rates in the developed world. So, outflows from JGBs are going to be curtailed. Second, the DXY and USD/JPY have a strong positive correlation, and this places the yen in a very enviable position as the dollar weakens in 2022 (Chart 28). A Final Word On Gold, Silver, And Precious Metals Chart 29Hold Some Gold Along with our commodity strategists, we remain bullish precious metals. In our view, inflation could prove stickier than most investors expect. This will depress real rates and support precious metals. Within the precious metals sphere, we particularly like silver and platinum.  Almost every major economy now has negative real interest rates. Gold (and silver) have a long-standing relationship with negative interest rates (Chart 29). Central banks are also becoming net purchasers of gold, which is bullish for demand. The true precious metals winner in 2022 could be silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 30). Second, gold is very expensive compared to silver (Chart 31). In general, when gold tends to make new highs (as it did in 2020), silver tends to follow suit. This means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both gold and palladium prices. Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart 30Hold Some Silver Chart 31Stay Short The GSR Concluding Thoughts Our currency positions, as we enter 2022, are biased towards a lower dollar, but we also acknowledge that there are key risks to the view. Our recommendations are as follows: The DXY will could touch 98 in the near term, but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Chart 32Hold Some AUD Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a basket of oil producers versus consumers once volatility subsides. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar (Chart 32). The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com​​​​​​​ Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary