Europe

Special Report

Executive Summary Central banks are aggressively tightening policy around the world. Their ability to rein in inflation without causing a recession depends upon the level of the real neutral rates. Australia, Canada, New Zealand, and Sweden have elevated r-stars, but the picture changes drastically when their large debt loads are factored in. While real policy rates remain below r-star across DM economies for now, a more rapid decline in supply-driven inflation would correct this situation. Consequently, a global recession does not constitute our base case for the next six months, although it is a growing threat. The ECB is front-loading interest rate increases while it can, but the destination of travel is not changing significantly. Global R-Star Bottom Line: The global r-star varies greatly around the world and debt sustainability concerns weigh on the real neutral rates of Australia, Canada, New Zealand, and Sweden. The US economy remains best capable of handling higher interest rates.   Chart 1Rising Global Inflation Inflation around G10 economies has been very strong and much more durable than originally hoped. As a result, inflation now averages 7.1% on a headline CPI basis and 4.6% based on core CPI across among G10 economies (Chart 1). Central banks are tightening policy aggressively to prevent this elevated inflation from becoming entrenched. Essentially, they are aiming to avert the emergence of the kind of inflationary mentality that prevailed in the 1970s, which caused stubborn inflation during that decade. This exercise is fraught with difficulty. The objective is to achieve a policy setting that is slightly above the neutral rate of interest, but not too much so. On the one hand, keeping policy too accommodative will increase the chances that an inflationary mentality will emerge; on the other hand, if policy is tightened too much, a recession will become unavoidable and deflationary risks will escalate. A sense of where the neutral rate for major economies lies is therefore necessary to draw that line in the sand. To do so, we estimate the real neutral rate of interest for major DM economies using the methodology we introduced seven weeks ago, when we evaluated the neutral rates for the major Eurozone economies. This exercise shows that, at the current level of interest rates and inflation, policy among major economies remains accommodative. However, if inflation decelerates sharply in the coming months in response to declining global supply constraints and lower commodity prices, the recent increase in policy rates will have already gone a long way to normalizing monetary policy around the world. A Simple Approach The methodology we use is based on the approach developed by Holston, Laubach, and Williams (HLW)  to estimate the neutral real interest rate – or “r-star.” Specifically, we run regressions between the real interest rates in the US, Japan, the UK, New Zealand, Canada, Australia, Sweden, and Switzerland versus trend GDP growth and current account balances, which approximate the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average of core CPI.1  Table 1Unadjusted R-Stars The results are shown in Table 1. New Zealand, Australia, and Canada have the highest real-neutral rate of the major economies. They have had stronger growth over the past 20 years because of their rapid population growth caused by high immigration rates. Moreover, their commodity-based economies and their booming construction sectors pushed up investment rates, which requires high interest rates to attract sufficient savings to finance. Sweden and the US follow. These two economies have lower population growth rates than the commodity producers; nonetheless, they outperform Japan and the other European nations in the survey on that dimension. Moreover, they fare comparatively well in terms of productivity growth, which implies that their trend growth – a key driver of the neutral rate – is also higher than that of the UK, Japan, Switzerland, or the Euro Area. The US’s r-star shows up as being slightly below what would be expected based on its potential GDP growth. This surprising outcome most likely reflects the role of the dollar in global FX reserves and its standing at the core of the global financial system. These two characteristics of the greenback create an important demand for dollar-denominated assets that is dissociated from US domestic economic fundamentals. This additional demand biases downward the US real neutral rate and suggests that weak trend growth abroad and global excess savings remain important forces for US financial markets. Chart 2Japan's Dissociated Real Rates Japan displays a surprisingly elevated real neutral rate of 0.1%. This result reflects the limitation of the approach. Japanese interest rates have been at zero since the late 1990s and real rates have been negatively correlated with inflation because of this nominal rigidity (Chart 2). However, while Japanese inflation has averaged a paltry 0.2% since 1997, it has nonetheless fluctuated with commodity prices and global economic activity. As a result, real rates have been essentially dissociated from Japanese domestic drivers. Hence, an empirical approach based on the evolution of domestic economic variables yields poor results for Japan. Instead, the lack of inflation when public debt has increased by 200% of GDP over the past 32 years and Japan’s large net international investment position imply that its r-star is inferior to that of the other countries in the sample, and thus should lie below -1%. For the Eurozone, we use the average result of our July study, which estimated the neutral rates of Germany, France, Italy, and Spain independently. Germany flatters this estimate since its real neutral rate stands near 0%. An average, excluding Germany, would be closer to -0.5%, or well below the US r-star. Meanwhile, the Swiss r-star is depressed by both a low population growth and the Swiss exceptional savings generation, as highlighted by its current account surplus that has averaged 8% of GDP over the past 20 years. Finally, the UK’s r-star stands at the bottom of the pack. The UK’s productivity growth has been very poor over the past ten years, averaging 0.7% per annum. This points to a weak potential GDP for that economy. Moreover, the hurdles to UK growth have only increased in recent years with the implementation of Brexit, which is hurting the availability of labor in the country, while putting the UK at an even greater disadvantage in European markets, its largest export destination. What About Debt? This approach to estimating r-star ignores a key dimension: debt sustainability. If we factor in this crucial variable, the level of interest rates causing economic activity to decelerate changes drastically for many countries. Chart 3Massive Real Estates Bubbles Since 2000, real estate prices have surged by 280%, 220%, 170%, and 200% in New Zealand, Canada, Australia, and Sweden, respectively. These gains dwarf the house price appreciation observed in the US, the UK, Japan, or Germany (Chart 3, top panel). This outperformance of house prices is particularly problematic because it does not reflect more rapid underlying cash-flow growth from the assets. Instead, the main driver of the stronger house prices in New Zealand, Canada, Australia, and Sweden has been the explosion of their price-to-rent and price-to-income ratios (Chart 3, bottom two panels). Rising real estate prices boosted economic activity relative to the underlying trend GDP of these countries. As a result, the long-term growth numbers of these four nations potentially overstate their underlying rate of growth. Even more importantly, real estate prices and activity are extremely sensitive to interest rates. Therefore, the risk of bursting bubbles in New Zealand, Canada, Australia, and Sweden limits how high interest rates may rise there without causing growth to plunge and deflationary spirals to emerge. Chart 4Rapidly Rising Debt Loads The accumulation of debt in these four countries accentuates the threats to growth created by real estate activity. The private-sector debt of New Zealand, Canada, Australia, and Sweden has risen much more quickly than has been the case in Germany and the US (Chart 4). Ultimately, these debt burdens create major headwinds against higher interest rates and suggest that the effective r-star of these nations lies well below the estimates constructed using only trend growth and the savings/investment balance. Table 2Drastic Changes Once Debt Is Accounted For To account for the private-sector leverage, we estimated new debt-adjusted r-stars. The impact of high debt loads on r-star estimates is evident in Table 2. The average real neutral rate of New Zealand, Australia, and Canada drops from 1.9% to -1.9%. In fact, Australia and Canada would sport the lowest r-star estimates of the nations under study. Sweden’s neutral rate also experienced a big decline from 0.6% to 0.2%. The US r-star estimate is also lowered by the addition of debt metrics in its equation, declining from 0.2% to -0.4%. The Eurozone average r-star experiences a significant decrease as well, driven mostly by Spain and France. The Swiss economy also sports a large private debt load, and its r-star is therefore curtailed from -0.75% to -1.3%. Finally, Japan’s r-star estimate barely changes, which confirms that the approach does not work well for that country. The greatest drawback of the method is that it is backward-looking. The main force that has brought down the global r-star over the past 20 years is the collapse in trend growth among most advanced economies (Chart 5). Consequently, neutral rates could improve from their current low levels if trend growth were to pick up in the coming years. On the positive side, the current age of the capital stock in both Europe and the US is extremely advanced (Chart 6), which suggests that a capex upturn is likely. Such an upturn would boost productivity and lift the r-star among most major economies. On the negative side, the growth of human capital is deteriorating as educational attainment stalls among most DM nations. The decline in the growth rate of human capital is a large threat to productivity over the coming decades. These problems are magnified in the Eurozone, as its high degree of economic fragmentation, lack of common fiscal policy, and higher regulatory burden create further handicaps to trend growth. Chart 5R-star And Global Growth Chart 6A Capex Revival? Bottom Line: Estimating the real neutral rates for the global economy often relies on trend growth and the savings/investment balance. However, such an approach often misses the vulnerability to higher interest rates created by high private-sector indebtedness. If this constraint is considered, the high r-star recorded in countries like New Zealand, Australia, or Canada is reduced dramatically. The US r-star also declines but significantly less so. As we already showed seven weeks ago, the same phenomenon is also visible in the Eurozone, albeit driven by France and Spain, not Germany or Italy. Investment Implications There are three main conclusions from the analysis above. First, the risk of a financial accident in commodity-producing economies is growing increasingly large. On the one hand, economies like New Zealand, Australia, and Canada are buoyed by the recent surge in commodity prices, with agricultural prices up 90% since their 2020 lows, metal prices up 68%, and energy prices up 340% since April 2020. On the other hand, the inflationary pressures created by robust commodity sectors invite the RBNZ, the RBA, and the BoC to lift interest rates quickly, which is hurting massively indebted private sectors. Already, in response to the 275bps and 300bps of hikes implemented by the RBNZ and the BoC, house prices in New Zealand have begun to buckle, down 12% and since their more recent peaks, and they are expected to plunge by as much as 25% in Canada by the end of next year. Chart 7NZD And CAD At A Disadvantage This suggests that non-commodity equities in Canada, Australia, and New Zealand, especially financials, could experience significant periods of underperformance, both against their domestic equity benchmark and global market averages. Additionally, while the NZD, AUD, and CAD all benefit from improving terms of trades, the potential for domestic weakness is such that these currencies are likely to lag their historical sensitivity to commodity price fluctuations. In fact, according to BCA’s foreign exchange strategist, the New Zealand and Canadian dollars are among the most expensive currencies in the G10 (Chart 7), and thus, it is likely to underperform other pro-cyclical currencies once the USD bull market reverses. Second, the neutral rate in the US has risen by 200bps relative to the rest of the world over the past seven years. The US economy has undergone a long deleveraging period in the wake of the GFC, which means that its private-debt-to-GDP ratio has declined relative to other advanced economies. Consequently, the vulnerability of the US economy to higher interest rates has decreased, even if relative US trend growth has not improved meaningfully. The market implications of this pickup in the neutral rate are manifold. To begin with, it allows US rates to rise further relative to other DM economies. BCA’s Global Fixed Income Strategy team continues to underweight US Treasurys in global fixed-income portfolios, especially relative to German Bunds (Chart 8). As a corollary, it also means that US financials are likely to continue to outperform their foreign peers, especially Canadian and Australian ones which will bear the brunt of the negative consequences of their debt bubbles. The increase in the US r-star relative to the rest of the world has been a key contributor to the dollar rally. It helps explain why the recent dollar strength has not hurt relative profit growth (Chart 9). However, the dollar is trading at a 32% premium to its purchasing power parity, or the same overvaluation as in 1985 and 2001. Thus, with the worsening US balance of payment picture, the US dollar is vulnerable to an eventual improvement in global growth next year. Chart 8US Rate Differentials Have Upside Chart 9The US Fares Better Chart 10Easy Or Not? Finally, despite the recent increase in rates, the high level of inflation recorded around the world implies that real policy rates are still well below r-star for major global economies, whether one uses actual inflation or the smooth formulation recommended by the HLW paper (Chart 10). This suggests that a recession is unlikely, especially in the US. The recession threat is higher in Europe but has little to do with policy. It is mostly a consequence of the massive terms of trade shock caused by the sudden jump in European energy prices in the wake of the Ukrainian war. However, because policy remains accommodative even in Europe, it follows that the Eurozone economy will rebound quickly once the worst of the energy shock is over next spring. Some humility is required. It is hard to gauge how much of the inflation surge over the past 18 months reflects supply factors. If inflation suddenly becomes much weaker because the easing in supply constraints has a greater-than-anticipated impact on inflation, real interest rates would jump rapidly around the world. In this scenario, policy rates could rise quickly and overtake r-star. This would mean that the disinflation impulse could rapidly morph into an outright deflationary environment, which implies that the odds of a deflationary bust like the one experienced in 1921 is greater than the market currently prices in.  Bottom Line: The debt-fueled real estate bubbles in the dollar-bloc economies suggests that they are at a greater risk of a financial accident than the US or the Eurozone. As a result, their financial sector looks vulnerable. Meanwhile, the higher US r-star compared to that of the rest of the world will continue to support higher yields in the US rather than in Europe or Japan. This phenomenon has been hugely positive for the US dollar, but it has likely run its course. Finally, global real interest rates remain below r-star estimates. Hence, the current slowdown is likely to prove to be a mid-cycle slowdown and Europe will rebound quickly from a potential recession caused by the recent surge in its energy prices. The ECB Joins The 75bps Club Last week, the ECB increased interest rates by 75bps, which brought its deposit rate to 0.75%. Interestingly, the euro did not rally much in response to this policy decision, even though it has not been fully discounted by the market. At first glance, the lack of responsiveness from European assets seems strange, especially since the vote for a 75bps rate hike was unanimous. The ECB is taking advantage of strong economic numbers to push up rates rapidly. The Eurozone Q2 GDP growth was robust at 0.6%, while the unemployment rate hit an all-time low of 6.6%. Meanwhile, inflation continues to beat consensus forecasts, with Eurozone core CPI and headline CPI standing at 4.3% and 9.1%, respectively in August. Chart 11Big ECB Revisions The market believes that more rapid interest rate hikes now will not translate into a much higher terminal rate, with the expected rates for June 2023 moving from 2.2% on September 7th to 2.4% after last Thursday’s decision. The ECB may have increased its inflation forecasts for the whole horizon, but it has also brought down GDP forecasts to 0.9% and 1.9% in 2023 and 2024, respectively (Chart 11). Moreover, ECB President Christine Lagarde went out of her way to telegraph to investors that the number of upcoming hikes was finite. The jumbo hike does not spell the start of a euro rally—for now. First, the lack of major change in the ECB’s terminal deposit rate is more important than the more rapid pace of hikes for the remainder of 2022. Second, the Fed is also lifting rates faster than investors expected ahead of the Jackson Hole meeting three weeks ago. Third, the euro remains vulnerable to any flare-ups in the energy market. True, natural gas and electricity prices have recently fallen, but the situation in Ukraine continues to be highly fluid, which suggests that volatility will linger in the energy market over the coming weeks.   Despite the near-term hurdles, the euro’s medium-term outlook is brightening. We are gaining confidence in our thesis that energy prices will peak once natural gas inventories have reached approximately 90% by November. Additionally, the support of the Governing Council’s doves for a 75bps hike suggests that they received something in exchange for their votes. In our view, this “something” is an activation of the Transmission Protection Instrument (TPI) before year-end. The TPI activation will allow for a normalization of the risk premia in the Italian debt market and will support the ECB’s ability to increase interest rates further down the road, despite the much lower r-star in Italy, Spain, and France than in Germany (Table 3). Table 3The Eurozone’s Different R-Stars Will Force The TPI’s Activation Bottom Line: The ECB may have delivered a jumbo hike last week, but its market impact was muted. Investors understand full well that the ECB is taking advantage of the recent bout of robust economic activity to front-load interest rate increases ahead of a likely economic contraction in Q4 2022 and Q1 2023. As a result, the terminal rate estimates have scarcely moved. Ultimately, we expect the ECB deposit rate to settle between 1.5% and 2% in the summer of 2023. While the move may not provide much of a boost to the euro in the near term, conditions are falling into place for a euro rally later this year.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1     For the US, we opted for core PCE, since it is the benchmark inflation measure the Federal Reserve uses.

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Cheap But Challenged European equities have bottomed in absolute terms, but they are still underperforming US ones. Eurozone equities are very cheap compared to US ones, but their profitability remains inferior. Five problems continue to hang over the relative performance of European stocks. The first problem is the Chinese and global growth outlook. The second problem is the natural gas crisis. The third problem is Europe’s expanding liquidity risk. The fourth problem is the weak euro. The fifth problem is Europe’s structural profitability weaknesses.     Bottom Line: European stocks may be inexpensive, but too many problems are hanging over their profit outlook. As a result, European shares are unlikely to outperform until natural gas prices peak and the ECB activates the TPI. Until then, continue to underweight European stocks in global equity portfolios.   European assets are on sale. Equities are trading at multigenerational lows against their US counterparts. Meanwhile, the euro is back below parity and embedding a 30% discount to purchasing power parity against the US dollar. These observations suggest that European stocks are very attractive relative to their US counterparts — but are they? Related Report  European Investment StrategyQuestions From The Road On July 4, 2022, we turned positive on European stocks in absolute terms. Nonetheless, we expected US stocks to outperform because of their larger weighting toward defensive and growth names, which derive greater benefit from lower rates, especially when economic activity remains vulnerable. At this point, we maintain this stance. European valuations are appealing, but the entry point is still not right because the global environment continues to be hostile to the relative performance of European equities. Attractive Valuations Anyway you cut it, European stocks are much less expensive than their US counterparts. In theory, these attractive valuations imply higher long-term rates of return in European markets compared to US ones. Chart 1Cheap European Stocks Based on the MSCI indices, the relative forward P/E ratio of Eurozone shares is 25% below that of US stocks, or the deepest discount in more than 20 years (Chart 1, top panel). European shares should naturally sport lower valuations than US ones due to sectoral biases. However, even when we adjust for those sectoral differences, European stocks stand out as exceptionally cheap. A P/E ratio calculated by giving equal weights to all the sectors in both Europe and the US reveals that, outside of the COVID-19 selloff, the European valuation discount has never been lower in the post-dotcom bubble era (Chart 1, bottom panel). Comparing individual sector performances to earnings reinforces that European stocks are uniquely inexpensive compared to US ones. Since 2018, the relative prices of most European sectors compared to their US competitors have underperformed relative earnings (Chart 2). Chart 2ABroad-based Cheapness Chart 2BBroad-based Cheapness The problem with valuations is that they can be misleading. If European earnings continue to underperform US ones, European equities are likely to underperform further. And, whether we adjust or not for sector composition, European earnings remain in a pronounced downtrend compared to US profits, which is driving relative performance (Chart 3). Perhaps there is hope for European earnings, but, in the short term, we doubt it. European earnings expectations have been downgraded already, with 2022 and 2023 earnings excluding the energy sector, already down 10% and 12% respectively since their February peak (Chart 4). However, five problems are likely to lead to a greater downgrade relative to the US in the coming months. They are the following: the Chinese and global growth difficulties, the energy market’s ructions, the European liquidity risk, the weakness in the euro, and Europe’s structural lack of profitability. Chart 3Earnings Are In The Driving Seat Chart 4Downward Revisions Have Begun Bottom Line: Compared to the US, European stocks are very cheap. However, European stocks will only begin to outperform once investors see reasons to upgrade European relative earnings. For now, too many problems continue to place Europe’s profit outlook at a disadvantage. Problem 1: Chinese And Global Growth Chart 5Europe Is More Cyclical than the US The performance of European equities relative to that of US stocks tracks the evolution of the global manufacturing PMI (Chart 5). This makes sense. Europe’s economy and markets are more specialized in the manufacturing sector, whether consumer or capital goods. Consequently, European earnings are also more geared to the fluctuations of global industrial activity and Chinese imports. Today, China remains one of the major risks to European stocks. Despite efforts by Beijing to stabilize growth, the private sector continues to retrench. The zero-tolerance toward COVID creates a powerful brake on animal spirits as lockdowns shift from one city to the next. Most crucially, the real estate sectors’ woes show no end in sight. Floor spaces sold, started, and completed are contracting at double-digit paces and real estate investment is declining at a 12% annual rate (Chart 6 top and second panels). Moreover, the 47% annual contraction in land purchases indicates that the situation will not improve soon. Consequently, consumer loan growth will decelerate further (Chart 6, bottom panel). While authorities are trying to manage the economic slowdown, they are still too concerned with real estate speculation to push as aggressively as the Chinese economy needs. Even the recent 19-point package from the State Council came with a warning that, although “the foundation of economic recovery is not solid,” Beijing will avoid “resorting to massive stimulus or compromising longer-term interests.” In this context, it is likely that China’s marginal propensity to consume will remain weak, that Chinese yields will decline further, and that the CNY will experience additional weaknesses. All these developments are consistent with a deeper underperformance of European equities (Chart 7). Chart 6China's Real Estate Industry Is Sick Chart 7Weak China = Weak Europe Looking at the global economy offers little hope. A weak China weighs on EMs’ growth prospects. Moreover, the strong dollar invites EMs’ central banks to tighten domestic liquidity and financial conditions, which historically results in lower growth. This softer economic activity ultimately hurts European earnings more than US ones and causes Eurozone shares to underperform US ones (Chart 8). Beyond EMs, the leading indicators of global economic activity do not inspire much confidence either. Arthur Budaghyan, BCA’s Emerging Market chief strategist, often highlights the downside risk to global exports, which would generate an underperformance of European earnings relative to those of the US. In fact, Taiwanese export orders, which lead global exports, are contracting anew. So is the Global Leading Economic Indicator (Chart 9). Ultimately, the tightening in global policy rates is doing what it should do: slowing global growth. Chart 8EM FCIs Matter To Europe's Relative Performance Chart 9Clouds Over The Global Economy Bottom Line: The weakness in Chinese economic activity is not over yet. Global growth will also continue to suffer as global exports are set to weaken considerably in the coming months. Together, these forces will hurt the earnings prospects of Europe compared to the US. Problem 2: The Energy Market Chart 10Pricey Nat Gas And Electricity Let’s be more specific here: natural gas continues to weigh more on Europe’s earnings prospects than those of the US. European natural gas prices have surged, even when compared to US ones. As a result, electricity prices have also increased across the Eurozone’s main economies (Chart 10). This is deeply negative for domestic economic activity and hurts the competitiveness of European businesses. Consequently, as long as natural gas prices climb higher, European profitability will deteriorate relative to that of US firms. Unsurprisingly, investors are deeply aware of these dynamics. The more natural gas prices rise, the greater European equities underperform. In fact, since mid-2021, Dutch natural gas prices have become the single best explanatory variable for the relative performance of European stocks (Chart 11). Natural gas is likely to remain a problem for European equities until the beginning of the winter. We are currently in the peak period of upward pressure on natural gas prices in Europe. Relentless inventory buildup introduced an inelastic buyer to the market, which is propelling natural gas prices to new heights even though consumption is receding (Chart 12, top panel). In response to these efforts, European natural gas inventories have hit 80% of capacity and are set to rise to 90% by November, even though Russian flows have collapsed (Chart 12, bottom two panels). However, in November, natural gas prices are likely to peak. The re-stocking effort will be completed, coal power will fill in many gaps, and selective conservation efforts will allow most industries and heating to function. Chart 11Europe vs US = Nat Gas Chart 12The Worse Is Now Bottom Line: The surge in natural gas prices is the key force currently hurting the relative performance of Eurozone equities. However, this negative dynamic is likely to fade in the winter because the current price jump reflects inventory building. By November, inventories will be at the 90% of capacity targeted by the European Commission and coal power will fill the remaining production gap. Until then, natural gas prices will continue to hurt European profit margins. Problem 3: European Liquidity Risk Chart 13Unhinged Credit Markets European equities are also hurt by an increase in risk premia relative to the US. Italian spreads continue to show upside and European junk spreads are widening compared to US ones (Chart 13). This problem could remain saliant in the coming months. The ECB is tightening policy in an economy already fettered by a severe energy shock. This process increases risk aversion. Moreover, because European inflation is likely to prove more sticky than that of the US this fall, this development will continue to hurt the price of European assets compared to US ones. Chart 14A Key Vulnerability The imbalances in the Euro Area create a further source of liquidity risk. The TARGET2 balances remain extremely large, which indicates that Dutch, Luxembourg, and German savings continue to finance France, Spain, and Italy (Chart 14, top panel). However, the import-boosting impact of high energy costs and the negative effects of weaker global growth on exports are likely to worsen the current account balance of the Eurozone, including that of Germany, which acts as the Eurozone’s banker (Chart 14, bottom panel). The decreasing savings of Germany and the Netherlands in conjunction with the wide difference in neutral rates between Germany and France, Italy and Spain increase the odds that peripheral spreads will widen further in the short term. However, this too is likely to be a temporary risk that ebbs after the winter. First, as we wrote four weeks ago, the differences in neutral rates will force the ECB to activate the TPI before year-end. Second, once energy prices peak, the downward pressure on European gross savings will also ease, which will restore liquidity conditions in European credit markets. Bottom Line: The combination of an ECB tightening policy in a weak economy as well as TARGET2 imbalances and declining savings increase the likelihood of a liquidity shortage in European debt markets. Tremors in the credit market would translate into further underperformance of European equities relative to US ones. Problem 4: The Weak Euro At first glance, the weak euro is positive for European equities since it subsidizes profitability. However, in a context in which costs of production are rising faster in Europe than in the US, this benefit is elusive. The weak euro is not translating into greater pricing power for European firms. The increase in producer prices supercharged by higher natural gas prices (among others) is not met by a commensurate rise in consumer prices. The same is true in the US, but to a much lesser extent; as a result, the ratio of CPI to PPI is declining in Europe relative to the US. Chart 15A Weak Euro Reflects Poor Pricing Power This lack of pricing power is an important driver of the weakness in the euro. EUR/USD closely tracks the evolution of the CPI-to-PPI ratio in Europe relative to the US (Chart 15). This confirms that a weaker euro is not helping the relative performance of European shares because it indicates a problem with the comparative profitability of European businesses. It also implies that the euro will weaken as long as Dutch natural gas prices are rising (Chart 15, bottom panel).  Historically, a weak euro is associated with underperforming European equities. At the most basic level, a depreciating euro arithmetically derails the common-currency performance of European shares. Moreover, because a falling euro is often linked to poor rates of return in the Euro Area, it corresponds to periods when investors prefer foreign shares to European ones. For now, we see a large left tail in short-term distributions of the EUR/USD’s returns, even if the long-term prospects of the euro are brighter. This also signifies that the euro will remain a hurdle for the relative performance of European shares in the coming weeks. Bottom Line: The lack of pricing power of European firms weighs on the profitability of Eurozone businesses compared to that of US ones and on the euro. As long as this problem persists, the euro will suffer, which implies additional weaknesses in the relative performance of European shares. Problem 5: Europe Structurally Poor Profitability Chart 16Europe's Structural Profitability Problem Since 2008, the EPS of the Eurozone MSCI benchmark have collapsed 73% compared to those of the US index. Moreover, this fall has followed a nearly straight line. This poor performance reflects an underlying structural challenge to European profitability. Europe’s low profit growth follows poor returns on assets. At first glance, lower levels of stock repurchases explain some of the underperformance of European earnings. However, the lower propensity of European firms to conduct buybacks mirrors their poor profitability. As Chart 16 highlights, European firms have much lower RoEs, RoAs, profit margins, and asset utilization rates than their US counterparts. The low profitability of European shares is multifaceted. To a large degree, it corresponds to the Eurozone’s anemic growth, whereby nominal as well as real GDP per capita continue to lag those of the US (Chart 17). This weak per-capita GDP is a consequence of the meager underlying productivity of the Euro Area. Many elements cause Europe’s lower productivity growth. The two most obvious culprits are the region’s greater economic fragmentation and its heavier regulatory burden when compared to the US. But also, the return on investment is much lower in Europe (Chart 17, bottom panel). The lower European return on investment is more complex. A key driver is the greater degree of misallocated capital in Europe than in the US. Europe’s capital stocks, especially in the periphery, represents a much greater share of GDP than it does in the US (Chart 18). A larger capital stock increases the odds that some previous capex was misallocated. Moreover, the greater prevalence of small businesses in Europe compared to the US also increases the likelihood of redundant and misallocated capital. Poor capital allocation hurts investment returns and productivity. Chart 17Weak Growth = Weak ROI Chart 18Too Much Capital Another reason for Europe’s poor profitability has nothing to do with productivity and tepid growth. European industries are less concentrated than US ones (Chart 19). Lower concentration means higher competition between businesses, which erodes markups and returns on assets.  Chart 19Smaller Profitability Moats In Europe None of Europe’s structural weaknesses in relation to profitability has been addressed. Consequently, this drag on the relative performance of Euro Area equities remains firmly in place, which warrants a significant discount in European equity valuations relative to US ones. Bottom Line: The last problem for European shares is the structural under profitability of the Eurozone. Because of lower productivity, misallocated capital, and lower industry concentration, European firms offer permanently weaker returns on assets than US businesses. Their disadvantage remains unaddressed, which suggests that structural forces are unlikely to generate a re-rating of European shares any time soon. Investment Implications Conditions are still not supportive for an outperformance of European equities relative to US ones. European stocks may have already bottomed in absolute terms and they are very cheap compared to US shares, but Euro Area earnings are set to underperform further. European stocks cannot beat US stocks until most of the five headwinds impacting Europe come to pass. The deceleration in Chinese and global growth, the surge in Dutch natural gas prices, the growing liquidity risk in the Eurozone, the collapse of EUR/USD, and the structural impediments to European profitability are just too strong collectively to allow Europe’s attractive valuation to crystalize into immediate high returns. Nonetheless, we cannot be dogmatic. Before year-end, we expect three of these variables to become favorable for European stocks. Namely, we anticipate the natural gas crisis to reach its apex around November 2022, the ECB to activate the TPI, which will tackle the budding illiquidity in European credit markets, and the euro to bottom. Hence, we are in the late stage of this year’s underperformance of European equities. An opportunity to upgrade Europe is around the corner – we are just not there yet. Even after all the cyclical and short-term negatives ebb, one key hurdle for European stocks will remain intact: the structural under profitability. This force suggests that periods of outperformance of European stocks are likely to be short-lived and that, as long as the profitability gap remains open, the structural relative bear market in European stocks will persist. Bottom Line: It is still too early to overweight European equities. Euro Area stocks are much cheaper than their US counterparts, but too many headwinds continue to blow that are likely to weigh on relative performance. Only after European natural gas prices peak will Europe enjoy a period of outperformance. This is unlikely to happen until this winter.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Our negative view on the summer rally is coming to fruition, with equities falling back on the negative geopolitical, macro, and monetary environment. China is easing policy ahead of its full return to autocratic government this fall. Yet the Fourth Taiwan Strait Crisis has only just begun. Tensions can still deal nasty surprises to global investors. It is essential to verify that relations will thaw after the US midterm and Chinese party congress is critical. Russia continues to tighten energy supply as predicted. Ukraine’s counter-offensive is pushing back the time frame of a ceasefire deeper into next year. Putin may declare victory and quit while he is ahead – but Russia will not be forced to halt its invasion until commodity prices fall significantly. Sweden’s election will not interfere with its NATO bid; Australia’s new government will not re-engage with China; Malaysia’s election will be a positive catalyst; South Africa’s political risks are reawakening; Brazil’s risks are peaking; Turkey remains a leading candidate for a negative “black swan” event. China’s Confluence Of Domestic And Foreign Political Risk Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 17.4% Bottom Line: Investors should stay defensive in the short run until recession risks and geopolitical tensions abate. Feature Last week we visited clients across South Africa and discussed a broad range of global macro and geopolitical issues. In this month’s GeoRisk Update we relate some of the key points in the context of our market-based quantitative risk indicators. While we were traveling, US-Iran negotiations reached a critical phase. A deal is said to be “closer” but we remain pessimistic (we still give 40/60 odds of a deal). The important point for investors is that the supply side of global oil markets will remain tight even if a deal is somehow agreed, whereas it will get much tighter if a deal is not agreed. China’s rollout of 1 trillion yuan ($146 billion) in new fiscal stimulus and rate cuts (5 bps cut to 1-year Loan Prime Rate and 15 bps cut to 5-year LPR) is positive on the demand side and supports our key view in our 2022 annual outlook that China would ease policy ahead of the twentieth national party congress. However, it is still the case that China is not providing enough stimulus to generate a new cyclical rally. Second quarter US GDP growth was revised slightly upwards but was still negative. Russia tightened control of European energy, as expected, increasing the odds of a European recession. Europeans are getting squeezed by rising energy prices, rising interest rates, and weak external demand. China Eases Policy Ahead Of Return To Autocracy China is facing acute political risk in the short term but it is also delivering more stimulus to try to stabilize the economy ahead of the twentieth national party congress this fall (Chart 1). The People’s Bank of China cut the benchmark lending rate by (1-year LPR) by 5 basis points, while authorities unveiled fiscal spending worth 1 trillion renminbi. Chart 1China's Confluence Of Domestic And Foreign Political Risk After the party congress, the regime is likely to “let 100 flowers bloom,” i.e. continue with a broad-based policy easing to secure the recovery from the Covid-19 shock. This will include loosening social restrictions and aggressive regulations against industrial sectors like the tech sector. It should also include some diplomatic improvements, especially with Europe. But it is only a short term (12-month) trend, not a long-term theme. Related Report  Geopolitical StrategyRoulette With A Five-Shooter China’s return to autocratic government under General Secretary Xi Jinping is a new, negative, structural factor and is nearly complete. Xi is highly likely to secure another decade in power and promote his faction of Communist Party stalwarts and national security hawks. The period around the party congress will be uncertain and dangerous. The exact makeup of the next Politburo could bring some surprises but there is very little chance that Xi and his faction will fail to consolidate power. The nomination of an heir-apparent is possible but of limited significance since Xi will not step down anytime soon or in a regular, predictable manner. Larger stimulus combined with power consolidation could spur greater risk appetite around the world, as it would portend a stabilization of growth and policy continuity. However, China’s underlying problems are structural. The manufacturing and property bust can be delayed but not reversed. China’s foreign policy will continue to get more aggressive due to domestic vulnerability, prompting foreign protectionism, export controls, sanctions, saber-rattling, and the potential for military conflict. Bottom Line: Investors should use any rally in Chinese assets over the coming 12 months as an opportunity to sell and reduce exposure to China’s historic confluence of political and geopolitical risk. Fourth Taiwan Strait Crisis Only Beginning The Fourth Taiwan Strait Crisis has only just begun. The previous three crises ranged from four to nine months in duration. The current crisis cannot possibly abate until November at earliest. Taiwan’s political risk will stay high and we would not buy any relief rally until there is a firm basis for believing tensions have fallen (Chart 2). Chart 2Taiwan: The Fourth Taiwan Strait Crisis If this year’s crisis were driven by US and Chinese domestic politics – the US midterm election and China’s party congress – then both Presidents Biden and Xi Jinping would already have achieved what they want and could proceed to de-escalate tensions by the end of the year – i.e. before somebody really gets hurt. The two leaders could hold a bilateral summit in Asia in November and agree to uphold the one China policy and status quo in the Taiwan Strait. We have given a 40% chance to this scenario, though we would still remain pessimistic about the long-term outlook for Taiwan. But if this year’s crisis is driven by a change in US and Chinese strategic thinking as a result of Russia’s invasion of Ukraine and China’s rising domestic instability, then there will not be a quick resolution on Taiwan. The crisis would grow next year, increasing the risk of aggression or miscalculation. We have given a 60% probability to this scenario, of which full-scale war comprises 20 percentage points. Bottom Line: Our geopolitical risk indicator for Taiwan spiked and Taiwanese equities rolled over relative to global equities as we expected. However, our oldest trade to capture the high long-term risk of a war in the strait – long Korea / short Taiwan – has performed badly despite the crisis. South Korea: China Stimulus A Boon But Not Geopolitics US-China rivalry – and the thawing of Asia’s once-frozen conflicts – is also manifest on the Korean peninsula, where the limited détente between the US and North Korea negotiated by President Donald Trump and Kim Jong Un has fallen apart. South Korea’s situation is not as risky as Taiwan’s but it is nevertheless less stable than it appears (Chart 3). Chart 3South Korea: Lower Geopolitical Risk Than Taiwan South Korea resumed its full-scale joint military exercise with the US, the Ulchi Freedom Shield, from August 22 to September 1. The drills involve amphibious operations and a carrier strike group. Full-scale drills were scaled down or cancelled under the Trump and Moon Jae-In administrations with the hopes of facilitating diplomacy and reducing tensions on the peninsula. North Korea was to discontinue ballistic missile tests and threats to the United States. But after the 2020 election neither Washington nor Pyongyang considered itself bound by this agreement. This year the US went forward with Ulchi Freedom even though regional tensions were sky-high because of House Speaker Nancy Pelosi’s visit to Taiwan and the De-Militarized Zone in Korea. The US is flagging its regional interests and power bases. North Korea is increasing the frequency of missile tests this year and is likely to conduct an eighth nuclear test. On August 17, it fired two cruise missiles towards the Yellow Sea. Pyongyang does not want to be ignored amid so many other geopolitical crises. It is emboldened by the fact that Russia and China will not be voting with the US for another round of sanctions at the United Nations Security Council due to the war in Ukraine and tensions over Taiwan. On August 11, South Korea responded to China’s insistence that the new government should abide by the “Three No’s,” i.e. three negatives that the Moon administration allegedly promised China: no additional deployments of the US’s Terminal High-Altitude Area Defense (THAAD) system, no Korean integration into US-led missile defense, and no trilateral military alliance with the US and Japan. Korea’s Foreign Minister Park Jin told reporters upon his return from China that the three no’s were “neither an agreement nor a promise.” South Korea’s new and conservative President Yoon Suk-yeol is unpopular and gridlocked at home but he is using the opportunity to reassert Korean national interests, including the US military alliance. Tension with the North and cold relations with China are coming at a time when the economy is slowing down. Korean GDP grew by 0.7% in Q2 2022 on a quarter-on-quarter basis, supported by household and government spending, while exports and investments shrank. Roughly a quarter of Korean exports go to China, its biggest trading partner. Korean exports to China have suffered due to China’s economic woes but cold relations could bring new economic sanctions, as China has hit South Korea before over THAAD. With the Yoon administration planning to bring the fiscal deficit back to below 3% of GDP next year, and a broader backdrop of weak Chinese and global demand, it is hard to find bright corners in the Korean economy in the near term. With Yoon’s basement level approval rating, he will resort to foreign policy to try to revive his political capital. Saber rattling and tough talk with North Korea and China will increase tensions in an already hot region – geopolitical risk is bound to stay high on the back of the Taiwan crisis. Bottom Line: On a relative basis, due to the ironclad US security guarantee, South Korea is safer than Taiwan. Investors wanting exposure to Chinese economic stimulus, electric vehicles, and semiconductors should go long South Korea. But some volatility is likely because the North’s eighth nuclear test will occur in the context of high and rising regional tensions. Australia: Stimulus Is Positive But No “Thaw” With China Australia is blessed with strong geopolitical fundamentals but it is seeing a drop in national security and economic security due to the deterioration of China relations. Domestic political turmoil is one of the consequences (Chart 4). Most recently Australia has been roiled by the revelation that former Prime Minister Scott Morrison secretly ran five ministries during the pandemic: the ministries of Home, Treasury, Finance, Resources, and Health. Chart 4Australian Geopolitical Risk Limited After an investigation and review by the Solicitor General Stephen Donaghue, Morrison’s action was determined to be legal, although highly inappropriate and inconsistent with the principles of responsible governance. Morrison’s appointments to these ministries were approved by the Governor General but the announcement or publication of appointments has always been the prerogative of the government of the day. One might think that this investigation is merely politically motivated but the Solicitor General is an apolitical position unlike the Attorney General, and Donaghue had been serving with Morrison, guiding him about the constitutionality of a vaccine mandate during the pandemic. The new Labor Party government of Prime Minister Anthony Albanese has vowed to be more transparent and will seek to enshrine a transparency measure into the law. Its political capital will improve, which is helpful for its ability to achieve its chief election promises. With the change of the government, it was hoped that there would be a thaw in the Australia-China relationship. China is Australia’s largest export destination and it erected boycotts against certain Australian exports in 2020 in response to Prime Minister Morrison’s inquiry into the origin of Covid-19. Hence Australia’s new defense minister, Richard Marles, met with his Chinese counterpart, General Wei Fenghe, on the sideline of the Shangri-La Dialogue in Singapore in June, which rekindled the hope that a thaw might happen. Yet a thaw is unlikely for strategic reasons, as highlighted by the Fourth Taiwan Strait Crisis, the Biden administration’s retention of former President Trump’s tariffs, and Australia’s fears of China’s rising influence in the Pacific Islands. The US and Australia are preparing for a long-term policy of containing China’s ambitions. A few days after his election, Prime Minister Albanese flew to Tokyo to attend a meeting of the Quadrilateral Security Dialogue (the Quad), sending a signal that there will be policy continuity with respect to Australian foreign policy. On May 26, Chinese fighter jets flew closely to an Australian surveillance plane on its routine operation and released aluminum chaffs that were ingested by the P8’s engines. An Australian warship, the HMAS Parramatta, was tracked by a People’s Liberation Army nuclear power submarine and multiple aircrafts on its way back from Vietnam, Korea, and Japan as part of its regional presence deployment in June. Currently Australia is hosting the Pitch-Black military exercise, with 17 countries participating. This exercise will last for three weeks – focusing on air defense and aerial refueling. It will also see the German air force with 13 military aircrafts deployed to the Indo-Pacific region for the very first time. They will be stopping in Japan after the exercise. As Australia’s policy towards China is unlikely to change, geopolitical risk will remain elevated. On the economic front, Australia’s misery index is at the highest point since 2000, with an unemployment rate at 3% and inflation at 6%. GDP growth in the first quarter was 0.8% compared to 3.6% in Q4 2021, propped up by government and household consumption while investment and exports contracted. The good news for the government is that it is inheriting this negative backdrop and can benefit from cyclical improvements in the next few years. Since the Labor government lacks a single-party majority in the Senate (where it must rely on the Greens and independents), it will be difficult for the government to raise new taxes. So far, Albanese has indicated that the budget to be tabled in October will focus on pre-election promises, which includes childcare, healthcare, and energy reforms. At worst, Australian government spending will stay flat, but it is unlikely to shrink considering Labor’s narrow control of the House of Representatives. Australian equities have not outperformed those of developed market peers despite high industrial metal prices. The stock market’s weak performance is attributable to the stumbling Chinese economy (Chart 5). Australian exports to China in June are still down 14% from June of last year. Chinese economic woes will be a headwind to Aussie growth and equity markets until next year, when Chinese stimulus efforts reach their full effect. Chart 5Australian Equities Have Yet to Benefit from Industrial Metal Prices On the other hand, the value of Australian natural gas and oil exports in June grew by 118% and 211% respectively (Chart 6), compared to June of last year. Chart 6Geopolitics: A Boon and Bane to Aussie Growth​​​​​ Bottom Line: As China will continue stimulating the economy and global energy markets will remain tight, investors should look for opportunities in Aussie energy and materials stocks. Malaysia Closes A Chapter … And Opens A Better One? Rarely do we get to revisit our positive outlook on Malaysia – a Southeast Asian state with an ability to capitalize on the US break-up with China. On August 23, the embattled ex-prime minister of Malaysia, Najib Razak, lost his final appeal at the Federal Court in Putrajaya after being found guilty in 2020 for abuse of power, criminal breach of trust, and money laundering tied to Malaysia’s sovereign wealth fund, 1MDB. The high court instructed that he serves his 12-years prison sentence immediately, becoming the first prime minister to be imprisoned in the country’s 60-years plus of history. Political risk has weighed on the Malaysian economy for almost a decade starting with the contentious 2013 general election, which saw the collapse of non-Malay voter support for the ruling party. Then came the 2015 Wall Street Journal bombshell about 1MDB, and then the 2018 general election that resulted in Malaysia’s first change of government since independence. The pandemic also led to political crisis in 2020. Each crisis resulted in a successive weakening of animal spirits and ever lower investments, resulting in Malaysia’s loss of competitiveness (Chart 7). Malaysia’s cheap currency was unable to increase its competitiveness, due to the low investments in the economy, and reflected higher political risks in the country (Chart 8). Chart 7Political Risk Undermines Competitiveness​​​​​​ Chart 8Cheap Currency Reflects Political Risk​​​​​​ Nonetheless this entire saga has proved that Malaysia’s legal system is independent and that its political system is capable of holding policymakers accountable. The next general election will come in a matter of months and recent state elections bodes well for the institutional ruling party, the United Malay National Organization (UMNO), and its coalition, Barisan Nasional. The coalition is managing to claw back support from the Malay and non-Malay voters. The opposition had the bad luck of ruling during the pandemic and its rocky aftermath, which has helped to rehabilitate the traditional ruling party. We have long seen Malaysia as a potential opportunity. But we would advise investors to wait until the new election is held and a new government takes power before buying Malaysian equities. With the conclusion of its decade-long 1MDB saga, we would turn more bullish if the next election produces a sizeable and enduring majority, if the use of racial and sectarian rhetoric tones down, and if the governing coalition pursues pro-competitiveness policies. Bottom Line: Structurally, Malaysia is one of the largest exporters of semiconductors and will benefit from the US’s shift away from China and attempt to reconstruct supply chains so they run through the economies of allies and partners. Russia: Escalating To De-Escalate? Russia increased the number of active military personnel in a move that points to an escalation of the conflict with Ukraine and the West, even as Ukraine wages a counter-offensive against Russia in Crimea and elsewhere. The time frame for a ceasefire has been pushed further into next year. As long as the war escalates, European energy relief will be elusive. Our risk indicators will rise again (Chart 9). Chart 9Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Ukraine will not be able to drive Russians out of territory in which they are entrenched. It would need a coalition of western powers willing to go on the offense, which will not happen. Russia is also threatening to cut off the Zaporizhzhia nuclear power plant, ostensibly removing one-fifth of Ukraine’s electricity. Once the Ukrainian counter-offensive grinds to a halt, a stalemate will ensue, incentivizing ceasefire talks – but not until then. The Europeans will have to support Ukraine now but will become less and less inclined to extend the war as they get hit with recession. Russia says it is prepared for a long war but that kind of rhetoric is necessary for propaganda purposes. The truth is that Russia does not have great success with offensive wars. Russia usually suffers social instability in the aftermath. The best indicator for the duration of the war is probably the global oil price: If it collapses for any reason then Russia’s war machine will fall short of funds and the Kremlin will probably have to accept a ceasefire. This what happened in 2014-15 with the Minsk Protocols. Putin will presumably try to quit while he is ahead, i.e. complete the conquest and shift to ceasefire talks, while commodity prices are still supportive and Europe is economically weak. If commodity prices fall, Russia’s treasury dries up while Europe regains strength. So while military setbacks can delay a ceasefire, Russia should be seen as starting to move in that direction. The deal negotiated with Turkey and the United Nations to ship some grain from Odessa is not reliable in the short run but does show the potential for future negotiations. However, a high conviction on the timing is not warranted. Also, the US and Russia could enter a standoff over the US role in the war, or NATO enlargement, at any moment, especially ahead of the US midterm election. Bottom Line: Ukraine’s counteroffensive and Russia’s tightening of natural gas exports increases the risk to global stability and economic growth in the short run, even if it is a case of “escalating tensions in order to de-escalate” later when ceasefire talks begin. Italy: Election Means Pragmatism Toward Russia Italy’s election is the first large crack in the European wall as a result of Russia’s cutoff of energy. The party best positioned for the election – the right-wing, anti-establishment party called the Brothers of Italy – will have to focus on rebooting Italy’s economy once in power. This will require pragmatism toward Russian and its natural gas. Regardless of whether a right-wing coalition obtains a majority or the parliament is hung, Italian political risk will stay high in the short run (Chart 10). Chart 10Italy: Election Brings Uncertainty, Then Economic Stimulus Although the center-left Democratic Party (PD) is narrowing the gap with the Brothers of Italy in voting intentions, it is struggling to put together an effective front against the right-wing bloc. After its alliance with the centrist Azione party and +Europa party broke down, PD’s chance of winning has become even slimmer. Even if the alliance revives, the center-left bloc still falls short of the conservative parties. Together, the right-wing parties account for just 33% of voting intentions (Democrats at 23%, Greens and Left Alliance at 3%, Azione and +Europa at 7%). By contrast, the right-wing bloc has a significant lead, with 46% of the votes (Brothers of Italy at 24%, Lega at 14%, Forza Italia at 8%). They also have the advantage of anti-incumbency sentiment amid a negative economic backdrop. Unless some sudden surprises occur, a right-wing victory is expected, with Giorgia Meloni becoming the first female prime minister in Italy’s history. This has been our base case scenario for the past several months. But what does a right-wing government mean for the financial markets? In an early election manifesto published in recent weeks, the conservative alliance pledged full adhesion to EU solidarity and dropped their previous euroskepticism. This helps them get elected and is positive for investors. However, there are also clouds on the horizon: In the same manifesto, the right-wing parties pledged to lower taxes for families and firms, increase welfare, and crack down on immigration. These programs will add to Italy’s huge debt pile and eventually lead to conflicts with the ECB and other EU institutions. In the manifesto, they stated that if elected, they would seek to amend conditions of Italy’s entitlement to the EU Recovery Fund, as the Russia-Ukraine war has changed the context and priorities significantly. This could potentially put the EU’s grants and cheap loans at risk. Under the Draghi government, Italy has secured about 67 billion euros of EU funds. According to the schedule, Italy will receive a further 19 billion Euros recovery funds in the second half of 2022, if it meets previously agreed upon targets. The new government will try to accept the funds and then make any controversial policy changes. On Russia, the conservative parties claimed that Italy would not be the weak link within EU. They pledged respect for NATO commitments, including increasing defense spending. Both Meloni and her Brothers of Italy have endorsed sending weapons to support Ukraine. Still, we think that due to Italy’s historical link with Russia and the need to secure energy supplies, the new government would be more pragmatic toward Russia. On China, Meloni has stressed that Italy will look to limit China’s economic expansion if the right-wing alliance wins. She stated that “Russia is louder at present and China is quieter, but [China’s] penetration is reaching everywhere.” China will want to use diplomacy to curb this kind of thinking in Europe. Meloni also stated that she would not seek to pursue the Belt and Road Initiative pact that Italy signed with China in 2019. In short, we stand firm on our recommendation of underweighting Italian assets at least until a new government is formed. Europe Gets Its Arm Twisted Further The United Kingdom is going through a severe energy, water, and inflation crisis – on top of the long backlog at the National Health Service – as it stumbles through the aftermath of Covid-19 and Brexit. The Conservative Party’s leadership contest is a distraction – political risk will not subside after it is resolved. The new Tory leader will lack a direct popular mandate but the party will want to avoid an early election in the current economic context, creating instability. The looming attempt at a second Scottish independence referendum will also keep risks high, as the outcome this time may be too close to call (Chart 11). Chart 11UK: Tory Leaders A Sideshow, Risks Will Stay High Germany saw Russia halt natural gas flows through Nord Stream 1 as the great energy cutoff continues. As we have argued since April, Russia’s purpose is to pressure the European economies so that they are more conducive to a ceasefire in Ukraine. Germany will evolve quickly and will improve its energy security faster than many skeptics expect but it cannot do it in a single year. The ruling coalition is also fragile, even though elections are not due anytime soon (Chart 12). Chart 12Germany: Geopolitical Risk Still Rising France’s political risk will also remain high (Chart 13), as domestic politics will be reckless while President Emmanuel Macron and his allies only control 43% of the National Assembly in the aftermath of this year’s election (Chart 14). Chart 13France: Lower Geopolitical Risk Than Germany Chart 14Macron Will Focus On Foreign Policy Spain is likely to see its coalition destabilized and early elections, much like Italy this year (Chart 15). Chart 15Spain: Early Elections Likely Sweden, along with Finland, will be joining NATO, which became clear back in April. In this sense it is at the center of Russia’s conflict with the West over NATO enlargement, so we should take a quick look at the Swedish general election on September 11. Currently the left-wing and right-wing blocs are neck and neck in the polls. While the current Social Democrat-led government may well fall from power, Sweden’s new pursuit of NATO membership is unlikely to change. The right-wing parties in Sweden are in favor of joining NATO. The two parties that oppose NATO membership are the left-wing Green and Left Party. The Social Democrats were pro-neutrality until the invasion of Ukraine and since May have spearheaded Swedish accession to NATO. The pro-neutrality bloc currently holds 43 seats in the 349-seats Riksdag. It has a supply-and-confidence arrangement with the current government and is currently polling at 13%. If it was willing and able to derail Sweden’s NATO bid, it would already have happened. So the general election in Sweden is unlikely to stop Sweden from joining. However, Russia does not want Sweden to join and the entire pre- and post-election period is ripe for “black swan” risks and negative surprises. One thing that could change with the election is Sweden’s immigration policy. The Social Democrats are pro-immigration (albeit pro-integration), while the right-wing bloc is less so. Sweden has received a great many asylum seekers since the Syrian refugee crisis in 2015 and will be receiving more from Ukraine and Russia (Chart 16). Chart 16Asylum Seekers to Surpass 2015 Refugee Crisis Our Foreign Exchange Strategist Chester Ntonifor points out that the increase in asylum seekers could augment Swedish labor force and increase its potential growth in the long run, while in the short run it could increase demand in the domestic economy. But an increase in demand could also exacerbate inflation in Sweden, especially considering how much the Riksbank is behind the curve vis-à-vis the ECB. Our European Investment Strategy recommends shorting EUR/SEK as Sweden is less vulnerable to Russian energy sanctions. Sweden produces most of its energy from renewable sources. Relative to Europe, Canada faces a much more benign political and geopolitical environment (Chart 17). However, within its own context, it will continue to see more contentious domestic politics as interest rates rise on a society with high household debt and property prices. The post-Covid-19 period will undermine the Justin Trudeau government over time, though it is not facing an election anytime soon. Canada continues to benefit from North America’s geopolitical advantage, though quarrels with China will continue, including over Taiwan, and should be taken seriously. Aside from any China shocks we expect Canadian equities to continue to outperform most global bourses. Chart 17Canada: Low Geopolitical Risk But Not Happy South Africa: The Calm Before The Storm South Africa’s economy remains in a low growth trap, which is contributing to rising political risk (Chart 18). Electricity shortages continue to dampen economic activity. Other structural issues like 33.9% unemployment, worsening social imbalances, and a split in the ruling party threaten to cause negative policy surprises. Chart 18South Africa: Institutional Ruling Party At Risk The South African economy has failed to translate growth outcomes into meaningful economic development, leaving low-income households (the median voter) increasingly disenfranchised, burdened, and constrained. Last year’s civil unrest was fueled by economic hardships that persist today. Without a significant and consistent bump to growth, social and political risks will continue to rise. Low-income households remain largely state dependent. Fiscal austerity has already begun to unwind, well before the 2024 election, in a bid to shore up support and quell rising social pressures (Chart 19). Chart 19South Africa: Fiscal Easing Ahead Of 2024 Vote The fact that the social scene is relatively quiet for now should not be seen as a sign of underlying stability. For example, two of the largest trade unions led a nationwide labor strike last week – while we visited clients in the country! – but failed to “shut down” the country as advertised. Labor union constituents noted the ANC’s economic failures, demanded immediate economic reform, and advocated for a universal basic income grant. This action blew over but the election cycle is only just beginning. Looking forward to the election, President Cyril Ramaphosa’s ANC is still viewed more favorably than the faction led by ex-President Jacob Zuma, but Ramaphosa has suffered from corruption allegations recently that have detracted attention from his anti-corruption and reform agenda and highlighted the party’s shortcomings once again. The ANC’s true political rival, the far-left Economic Freedom Fighters (EFF), have so far failed to capitalize on the weak economic backdrop. The EFF is struggling with leadership battles, thus failing to attract as many soured ANC voters as otherwise possible. If the Economic Freedom Fighters refocus and install new leadership, namely a leader that better reflects the tribal composition of the country, the party will become a greater threat to the ANC. But the overall macro backdrop is a powerful headwind for the ANC’s ability to retain a parliamentary majority. Global macro tailwinds that supported local assets in the first half of the year are experiencing volatility due to China’s sluggish growth and now stimulus efforts. Cooling metals prices and slowing global growth have weighed on the rand and local equity returns. But now China is enacting more stimulus. China is South Africa’s largest trading partner, so the decision to ease policy is positive for next year, even though China’s underlying structural impediments will return in subsequent years. This makes it hard to predict whether South Africa’s economic context will be stable in the lead-up to the 2024 election. As long as China can at least stabilize in the post-pandemic environment in 2023, the ANC will not face as negative of a macro environment in 2024 as would otherwise be the case. Investors will need to watch the risk of political influence on the central bank. Recently the ANC resolved to nationalize the central bank. Nationalization is mostly about official ownership but a change in the bank’s mandate was also discussed. However, to change the bank’s mandate from an inflation target to an unemployment target, the ANC would need to change the constitution. Constitutional change requires a two-thirds vote in parliament, a margin the ANC does not hold. Constitutional change will become increasingly difficult if the ANC sheds more support in the 2024 general election, as expected. Bottom Line: Stay neutral on South Africa until global and Chinese growth stabilize. Political risk is rising ahead of the 2024 election but it is not necessarily at a tipping point. Brazil And Turkey: Election Uncertainty Prevails We conclude with two brief points on Brazil and Turkey, which both face important elections – Brazil immediately and Turkey by June 2023. Both countries have experienced different forms of instability as emerging middle classes face economic disappointment, which has led to political challenges to liberal democracy. Brazil – President Jair Bolsonaro’s popular support is rallying into the election, as expected, but it would require a large unexpected shift to knock former President Lula da Silva off course for re-election this October (Chart 20). Brazil’s first round vote will be held on October 2. If Lula falls short of the 50% majority threshold, then a second round will be held on October 30. Bolsonaro faces an uphill battle because his general popularity is weak – his support among prospective voters stands at 35% compared to Lula at 44% today and Lula at 47% when he left office in 2010. Meanwhile the macroeconomic backdrop has worsened over the course of his four-year term. Bolsonaro will contest the election if it is close so Brazil could face significant upheaval in the short run. Chart 20Brazil: Risk Will Peak Around The Election Turkey – President Recep Erdogan’s approval rating has fallen to 41%, while his disapproval has risen to 54%. It is a wonder his ratings did not collapse sooner given that the misery index is reaching 88%, with headline inflation at 78%. Having altered the constitution to take on greater presidential powers, Erdogan will do whatever it takes to stay in power, but the tide of public opinion is shifting and his Justice and Development Party is suffering from 21 years in power. Erdogan could interfere with NATO enlargement, the EU, Syria and refugees, Greece and Cyprus, North Africa and Libya, or Israel in a way that causes negative surprises for Turkish or even global investors. Turkey will be a source of “black swan” risks at least until after the general election slated for June 2023 (Chart 21). Chart 21Turkey: A Source Of 'Black Swans' We will revisit each these markets in greater detail soon. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com ​​​​​​​Yushu Ma Research Analyst yushu.ma@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar