Japan

This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.

Executive Summary Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues In this report, we discuss our move last week to shift to a below-benchmark overall global duration stance in more detail. Our strongest conviction view on developed market government bonds is underweighting US Treasuries. The outcome of last week’s FOMC meeting, where the Fed committed to a rapid shift to restrictive US monetary policy, supports that position. Our strongest conviction overweight is on Japan, with the Bank of Japan both willing and able to maintain its cap on longer-term JGB yields. We are also overweight countries where it will be difficult for central banks to lift rates as much as markets expect – core Europe, Australia and Canada. The explosion in UK bond yields, and collapse of the British pound, seen after last week’s UK “mini-budget” shows that investors have not lost the power to punish fiscal and monetary policies that are non-credible - like a massive debt-financed tax cut at a time of high inflation. As a result, the Bank of England will now be forced to raise rates much more than we had been expecting, and Gilts will remain extremely volatile in the near-term. Bottom Line: Maintain a below-benchmark overall duration stance in global bond portfolios. Stay underweight US Treasuries. Upgrade exposure to government bonds in Japan and Canada to overweight, but tactically downgrade UK Gilts to underweight until a more market-friendly policy mix leads to greater stability of the British pound. Feature We shifted our recommended stance on overall global portfolio duration to below-benchmark in a Special Alert published last week. In this report, we go into the rationale for that move in more detail, and present specific details of that shift in terms of allocations by country across the various yield curves. Related Report  Global Fixed Income StrategyReduce Global Portfolio Duration To Below-Benchmark The global inflation and monetary policy backdrops remain toxic for bond markets. Last week saw interest rate increases from multiple developed economy central banks, including the Fed and Bank of England (BoE). The magnitudes of the rate hikes unnerved bond investors, with even the likes of perennial low yielders like the Swiss National Bank and Riksbank lifting rates by 75bps and 100bps, respectively. The Fed followed up its own 75bp hike by digging in its heels on the need for additional policy tightening after the 300bps of hikes already delivered this year (Chart 1). Fed Chair Jerome Powell strongly hinted that a policy-induced US recession is likely the only way to return overshooting US inflation back to the Fed’s 2% target. This triggered a breakout of the benchmark US 10-year Treasury yield above 3.5%. But the real fireworks in global bond markets occurred after the UK government announced its “mini-budget” last Friday that included massive tax cuts to be funded by debt issuance, triggering a sharp decline in the British Pound and spike in UK Gilt yields – a move that spilled over into other bond markets, pushing government bond yields to cyclical highs in the US and euro area. Chart 1Central Banks Keep Trying To “Out-Hawk” Each Other The Global Bond Bear Market Continues The Global Bond Bear Market Continues Chart 2Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation Yields Are Now Driven By Rate Hike Expectations, Not Inflation We had been anticipating another move upward in global bond yields for this cycle, and we shifted to a below-benchmark overall global duration stance in advance of the Fed and BoE meetings last week. We see this next move higher in yields as being driven not by rising inflation expectations but by an upward repricing of interest rate expectations, leading to additional increases in real bond yields (Chart 2). Trying to pick a top in bond yields has now become a game of forecasting the level to which policy rates must rise in the current global monetary tightening cycle. On that front, there is still scope for rate expectations, and bond yields, to move higher in most developed market countries, justifying our downgrade of our recommended overall duration exposure to below-benchmark. Shifting rate expectations also lead to the changes in country bond allocations we announced last week. Rate Expectations And Country Bond Allocations Our proxy for medium-term nominal terminal rate expectations in developed market countries, the 5-year/5-year forward overnight index swap (OIS) rate, has been tracking 10-year bond yields very closely in the US and UK and, to a lesser extent, Europe (Chart 3). In those regions, the OIS curves are pricing in an increasing medium-term level of policy rates, leading to markets repricing government bond yields higher. In the US, the OIS curve is pricing in a 2023 peak for the fed funds rate of 4.67%, but with only a modest path of rate cuts in 2024 and 2025, leading to a 5-year/5-year OIS projection of 3.36% as of Monday’s market close. After the Gilt market rout, the UK OIS curve is now pricing in a 2023 peak Bank Rate over 6%, with our medium-term nominal rate proxy settling at 3.69%. In the euro area, the OIS curve is discounting a 2023 peak in the ECB policy rate of 3.22%, with a 5-year/5-year forward OIS rate of 2.7%. For all three of those regions, the market is now pricing in the highest peak in rates for the current tightening cycle. That is not the case in Canada or Australia, where rate expectations and longer-term bond yields are still below cyclical peaks (Chart 4). Japan remains the outlier, with the Bank of Japan’s yield curve control keeping 10-year JGB yields capped at 0.25%, even with the Japan OIS curve pricing in a medium-term terminal rate of 0.75%. Chart 3Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Rising Yields Reflect Higher Terminal Rate Expectations Chart 4Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights Our High-Conviction Government Bond Overweights After looking at all the repricing of interest rate expectations and bond yields, we can determine our preferred government bond allocations within our strategic model bond portfolio framework. The US Remains Our Favorite Government Bond Underweight The new set of interest rate forecasts (“the dots”) presented at last week’s Fed meeting showed that the median FOMC member was forecasting the fed funds rate to rise to 4.4% by the end of 2022 and 4.6% by the end of 2023, before falling to 3.9% and 2.9% and the end of 2024 and 2025, respectively. Those are all significant increases from the June dots, where the expectations called for the funds rate to hit 3.4% by end-2022 and 3.8% by end-2023. The median Fed forecasts are now broadly in line with the pricing in the US OIS curve for 2022-2024, although the market expects higher rates than the FOMC in 2025 (Chart 5). Chart 5USTs Still Vulnerable To Additional Fed Hawkish Surprises The Global Bond Bear Market Continues The Global Bond Bear Market Continues There has been a lot of back and forth between the Fed and the markets this year, but the market has generally lagged the Fed interest rate projections for 2023 and 2024 before last week. Market pricing is now in line with the Fed dots, as investors have adjusted to the increasingly hawkish message from Fed officials that are focused solely on slowing growth, and tightening financial conditions, in an effort to bring US inflation down. We see the US Treasury curve as still vulnerable to additional hawkish messaging from the Fed, and a potentially higher-than-anticipated peak in the funds rate versus the FOMC dots. The US consumer is facing a lot of headwinds from higher interest rates and rising food and gasoline prices. However, the latter has fallen 26% from the June 13/2022 peak and is acting as a “tax cut” that also helps reduce US inflation expectations (Chart 6). Consumer confidence measures like the University of Michigan expectations survey have already shown improvement alongside the fall in gas prices, which has boosted real income expectations according to the New York Fed’s Consumer Survey (bottom panel). Even a subtle improvement in consumer confidence due to some easing of inflation expectations can help support a somewhat faster pace of consumer spending at a time of robust labor demand and accelerating wage growth. The Atlanta Fed Wage Tracker is now growing at a year-over-year pace of 5.7%, while the ratio of US job openings to unemployed workers remains near a record high (Chart 7). Fed Chair Powell has noted that the Fed must see significant weakening of the US jobs market for the Fed to consider pausing on its current rate hike path. So far, there is little evidence pointing to a loosening of US labor market conditions that would ease domestically-generated inflation pressures. Chart 6Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Lower Gas Prices Can Provide A Lift To US Consumer Spending Chart 7A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish A Tight US Labor Market Will Keep The Fed Hawkish Chart 8Stay Underweight US Treasuries Stay Underweight US Treasuries Stay Underweight US Treasuries We expect overall US inflation to decelerate next year on the back of additional slowing of goods inflation, but will likely settle in the 3-4% range in 2023 given stubbornly sticky services inflation and wage growth. The Fed should follow through on its current interest rate projections, with a good chance that rates will need to be pushed up even higher in response to resilient labor market conditions in the first half of 2023. The risk/reward still favors higher US Treasury yields over at least the next 3-6 months, particularly with an improving flow of US data surprises and with bond investor duration positioning now much closer to neutral according to the JPMorgan client survey (Chart 8). Bottom Line: The US remains our highest conviction strategic government bond underweight in the developed markets. Recommended Allocations In Other Countries The path for monetary policy rates outside the US shows a similar profile as in the US, with a “front loading” of rate hikes to mid-2023 followed by modest rate cuts over the subsequent two years (Chart 9). The OIS-implied path for the level of rates is nearly identical in the US, Australia and Canada. On the other hand, markets are discounting much lower of levels of policy rates in Europe and Japan compared to the US, and a considerably higher path for rates in the UK (more on that in the next section). Chart 9Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes Markets Priced For Global 'Front-Loaded' Rate Hikes We would lean against the US-like pricing of interest rates in Australia and Canada. Based on work we published in a recent Special Report along with our colleagues at BCA Research European Investment Strategy, the neutral real interest rate (“r-star”) is estimated to be deeply negative in Australia and Canada after adjusting for the high level of non-financial debt in those countries (Table 1). That financial fragility makes it much less likely that the Bank of Canada and Reserve Bank of Australia can raise rates as much as the Fed. Table 1Some Big Swings In Our R* Estimates When Including Debt The Global Bond Bear Market Continues The Global Bond Bear Market Continues US-like interest rates would almost certainly trigger a major downturn in house prices and household wealth given the inflated housing values in those two countries – the growth of which is already slowing rapidly in response to rate hikes delivered in 2022. We are maintaining our overweight recommendation on Australian government bonds, while we upgraded Canada to overweight from neutral after last week’s duration downgrade. Chart 10Move To Overweight Japan Move To Overweight Japan Move To Overweight Japan We are also staying overweight on German and French government bonds, as the ECB is unlikely to deliver the full extent of rate increases discounted in the European OIS curve. Our estimated debt-adjusted r-star is also quite negative in the euro area, suggesting that financial fragility issues (due to high government debt in Italy and high corporate debt in France) will likely limit the ECB’s ability to continue with recent chunky rate increases for much longer. In Japan, we continue to view JGBs as an “anti-duration” instrument, given the Bank of Japan’s persistence in maintaining negative interest rates and yield curve control. That makes JGBs a good overweight when global bond yields are rising and a good underweight when global bond yields are falling (Chart 10). Given our decision to reduce our recommended duration exposure to below-benchmark, the logical follow through decision is to upgrade JGBs to overweight. The only remaining country to consider is our view on UK Gilts, which has now become more complicated. Anarchy In The UK The selloff in the UK Gilt market has been stunning in its ferocity. Dating back to last Thursday’s 50bp rate hike by the BoE, the 10-year UK Gilt yield has jumped 120bps and now sits at 4.52%. The increase in yields was identical at the front-end of the Gilt curve, with the 2-year yield jumping 120bps to 4.68%.  The surge in longer-term Gilt yields stands out to the rise in bond yields seen outside the UK, as it also incorporates an increase in our estimate of the UK term premium – a move that was not matched in other countries (Chart 11). The rise in Gilt yields was also much more concentrated in real yields compared to inflation expectations (Chart 12), as markets aggressively repriced the path for UK policy rates after the UK government’s announced debt-financed fiscal package, including £45bn of tax cuts. Chart 11Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Upward Repricing Of Bond Yields Continues Chart 12The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The Gilt Market Becomes Unhinged The UK’s National Institute for Economic And Social Research (NIESR) estimates that the combined impact of the tax cuts and additional spending measures would increase the UK government deficit by a whopping £150bn, or 5% of GDP. The NIESR also estimated that the fiscal measures, including the previously-announced plan for the UK government to cap energy price increases, would result in positive UK GDP growth in the 4th quarter and also lift annual real GDP growth to 2% over 2023-24. The UK government now faces a major credibility issue with markets on its announced fiscal plans. The sheer size of the package, coming at a time when the US economy was already operating at full employment with high inflation, invites a greater than expected monetary policy tightening response from the BoE. The UK OIS curve now forecasts a peak in rates of 6.3% in October 2023, up from the current 2.25%. That would be a massive move in rates in just one year from a central bank that has been relatively gun shy in lifting rates since the 2008 financial crisis, even during the current inflation overshoot. New UK Prime Minister Liz Truss, and her new Chancellor of the Exchequer Kwasi Kwarteng, have both noted they would prefer a mix of looser fiscal policy (aimed at boosting the supply side of the economy to lift potential growth) with tighter monetary policy that would prevent asset bubbles and inflation overshoots. While there is certainly merit in any plan designed to boost medium-term growth by lifting anemic UK productivity through supply-side reforms, the timing of the announcement could not have been worse. Just one day earlier, the BoE announced a plan to go forward with the sale of Gilts from its balance sheet accumulated during quantitative easing. The Truss government needs to find buyers for all the Gilts that must be issued to pay for the tax cuts and stimulus, but the BoE will not be one of them. In the end, however, the BoE’s expected path for interest rates matters more than the increase in Gilt supply in determining the level of Gilt yields and the slope of the Gilt curve. The NIESR estimates that the UK public debt/GDP ratio will rise to 92% by 2024-25, versus its pre-budget forecast of 88%. While that is a meaningful increase, the correlation between the debt/GDP ratio and the slope of the Gilt curve has been negative for the past few years (Chart 13, top panel). The stronger relationship is between the slope of the curve and the level of the BoE base rate (bottom panel), which is pointing to an inversion of the 2-year/30-year curve if the BoE follows market pricing and lifts rates to 6%. Our view dating back to the early summer was that a low neutral interest rate would prevent the BoE from lifting rates as much as markets were discounting without causing a deep recession, lower inflation and, eventually, a quick reversal of rate hikes. The huge UK fiscal stimulus package changes that calculus, as the nominal neutral rate that will be needed to bring UK inflation back to target is likely now much higher. We have always believed that when a thesis underlying an investment recommendation is challenged by new information, it is best to adjust the recommendation to reflect the new facts. Thus, this week, we are tactically downgrading UK Gilts to underweight in our model bond portfolio framework. We still see a significant medium-term opportunity to go overweight Gilts, as UK policy rates pushing into the 4-6% range are not sustainable. However, the BoE will likely have no choice to begin lifting rates at a much more aggressive pace to restore UK policy credibility, especially with the British pound under immense selling pressure (Chart 14). Despite rumors of an inter-meeting rate hike by the BoE this week to try and support the pound, that is likely too risky a step for the BoE to take as it would invite a battle with investors and currency speculators. Such a battle would be difficult to win without a more credible and market-friendly medium-term fiscal policy from the Truss government. Chart 13The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts The BoE Matters More Than Debt Levels For Gilts Chart 14Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts Tactically Move To Underweight UK Gilts   Bottom Line: We will review our UK Gilt stance once there are more clear signals of stability in the pound, but for now, we will step aside and limit our recommended exposure to Gilts – even after the huge selloff seen to date, which likely has more to go. Summarizing All The Changes In Our Model Bond Portfolio All the changes to our recommended duration exposure and country allocations after the past week, including the new weightings in our model bond portfolio, are shown in the tables on pages 14-16. To summarize: We moved the overall recommended global duration exposure to below-benchmark, and shifted the model bond portfolio duration to 0.9 years below that of the custom benchmark index. We increased the size of the US Treasury underweight, and moved Canada and Japan to overweight. We moved the UK to underweight, on top of the reduction in UK duration exposure that was part of last week’s move to reduce overall portfolio duration. We are also cutting exposure to UK investment grade corporates to underweight, as part of an overall move to reduce UK risk in the portfolio. We slightly increased the overweight in Germany. In next week’s report, we will present the quarterly performance review of our model bond portfolio and, more importantly, we will present out scenario-based return expectations after all the changes made this week. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com     GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The Global Bond Bear Market Continues The Global Bond Bear Market Continues The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) The Global Bond Bear Market Continues The Global Bond Bear Market Continues

Listen to a short summary of this report     Executive Summary Sales & Profit Margins: The Two Propellers That Powered The Post-GFC US Rally What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? US equity markets underperformed the global benchmark by 10% over 2000-08. Since then, the US has outperformed the global benchmark by about 170%. So, what has driven the US’ chartbusting performance in the post-GFC period? If we break down the US’ price performance into three parts – namely price-to-earnings ratio, net profit margins, and sales – then it becomes clear that growth in the latter two elements played a key role in driving US outperformance in the post-GFC era. Can the US’ outperformance relative to global markets persist going forward? It appears unlikely that the US’ high profit margins can sustain these levels of growth going forward. Distinct from the mean reversion argument, the US’ high profit margins are unusually concentrated amongst a fistful of firms.  US firms may also find it challenging to maintain high sales growth as US GDP growth slows and given that America’s antitrust philosophy may soon undergo a once-in-a-generation change. Finally, it is worth noting that ‘sector composition’ effects played a significant role in driving US outperformance over 2008-22. Given that we expect outperforming sectors like Tech to become underperformers, this effect could become weaker going forward, thereby subverting another source of the US’ outperformance.   Bottom Line: Forecasting is a tenuous science but given that the two prime propellers of the US’ performance engine are likely to confront headwinds going forward, investors should consider reducing allocations to US equities over a longer term, strategic horizon.   Dear Client,  I am meeting clients in Asia this week while also working on our Fourth Quarter Strategy Outlook, which will be published next week, followed by my webcast the week after. In lieu of our regular report this week, you are receiving a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards,  Peter Berezin, Chief Global Strategist US Stock Market Dominance – It Wasn’t Always This Way Let us assume that you could travel back in time, and today was December 31, 2008. On this day you know that US and Japanese equity markets have underperformed the global benchmark (Chart 1). You also know that Europe (i.e., EU-27) has done marginally better than the US, while Emerging Markets (EM) have been the star outperformer. Let us further assume that by close of play today you have to deploy US$10bn across these four equity markets (across the US, Europe, Japan, and EM).  As if the task of taking this decision on the last day of this historic year was not enough, let us assume that the funds you invest must be locked in until the fall of 2022. Finally, let us add one more condition to this task – let us suppose that you have no idea how markets would perform over the 2008-22 period, but you have perfect foresight about how the nominal GDP of these four regions would look like in 2022. Specifically, you know that EM GDP will have a terrific run between 2008 to 2022, US GDP will increase but by a far less impressive degree, European GDP will grow only slightly, and Japan’s GDP would be lesser in 2022 than it was in 2008 (Chart 2).  Chart 1US Equities Underperformed The Global Benchmark By 10% Over 2000-08 US Equities Underperformed The Global Benchmark By 10% Over 2000-08 US Equities Underperformed The Global Benchmark By 10% Over 2000-08 Chart 2EM GDP Has More Than Doubled Since The GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 3US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD US Equities Outperformed The Global Benchmark By About 170% Over 2008-22YTD If you were to take an investment decision based only this information, what is certain is that the fund you manage would underperform by a painful degree. This is because we now know that even though US markets had poor momentum in 2008, and the US’ GDP expansion paled relative to EM, US equity markets outperformed global markets by a wide margin since 2008 (Chart 3). On the other hand, despite positive momentum and high GDP growth, EM emerged as a distant second-best performer. Japan miraculously made it to third place despite a contraction in nominal GDP, and finally Europe ended up being the worst performer. If market momentum and GDP growth cannot explain these market movements, then what drove the US' outstanding performance in the post-GFC period? In this Special Report, we delve into answering this question in detail. The purpose of peeling the onion of the US' performance is simple – we hope to extract the insights that investors need to construct alpha-generating portfolios, in a world where forward time travel is not a possibility (yet). The US’ Performance Has Been Powered More By Earnings, Less By Valuations The two basic building blocks of any equity index are its earnings and its price-to-earnings ratio. The former captures the fundamentals backing an index, while the latter quantifies the valuation element. Breaking down the US’ performance into these two parts shows that earnings have been the prime factor that have propelled the rise of US equity markets in the post-GFC era (Chart 4). That earnings have been an important driver of the US’ outperformance becomes even more apparent when US earnings are compared to that of other major markets. For instance, the steep expansion in US earnings contrasts with the situation across the Atlantic. In Europe, earnings have trended lower relative to the global benchmark since 2008 and an increase in relative valuations has helped lend a floor to the index (Chart 5). The earnings report card for Japan and EM, on the other hand, have been surprisingly similar as earnings failed to rise meaningfully in both these geographies in the post-GFC period (Chart 6 and 7). Chart 4Earnings Have Played A Key Role In Propelling The Post-GFC US Rally What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 5European Equities Supported More By Valuation Multiples What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 6Earnings Growth Has Been Unimpressive In Japan Too What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 7Earnings Have Trended Lower In EM Since 2008 What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? In summary, the US' price-to-earnings ratio has had a meaningful role in driving US outperformance in the post-GFC period (Chart 8), but earnings expansion has played an outsized role (Chart 9). Chart 8Relative Valuation Multiples Have Played A Key Role In Supporting European Markets What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 9Earnings Expansion In The US Has Been Phenomenal What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? In fact, the growth in earnings in the US in the post-GFC era has been so noteworthy that if US equity market prices were to be broken down into its two building blocks i.e., earnings and price-to-earnings ratio, then the lion’s share of US equity market prices today would be attributed to its earnings (Chart 10). Expectedly, this contrasts with the situation in Europe where equity market prices have managed to stay afloat owing to a re-rating in its price-to-earnings ratio (Chart 11). These attribution analysis numbers are not meant to be taken literally, but rather, reflect the relative role played by earnings and price-to-earnings ratios in supporting the prices of regional indices. Chart 10US Equities: Supported More By Earnings What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 11EU Equities: More Reliant On Multiples What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The Unsung Hero Behind The US’ Outperformance - Record Sales Expansion The index of a region can also be envisaged as the product of three elements, namely: (1) its price-to-earnings ratio; (2) its net profit margins; and (3) its sales. In other words: Price = (Price / Earnings) x (Earnings / Sales) x (Sales) While the US' healthy earnings tend to attract disproportionate investor attention, this formulation shows how a surge in US sales was the bigger driver of US outperformance (Chart 12). US profit margins experienced a sharp surge relative to global profit margins over the 2008-12 period, but then this parameter flatlined. US sales, on the other hand, have managed to register a steady march upwards over the entirety of the post-GFC period. The growth in sales of listed American corporations has in fact been so remarkable that a grand total of ten American firms now have annual sales of over $200 billion – which marks an all-time high for the US (Chart 13). Chart 12Post-GFC US Rally Powered By Record Sales Expansion What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 13The US Is Home To Ten Firms With Revenues Of +$200bn What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Furthermore, the US’ lead on sales today is meaningful not only by its own historical standards, but by cross-country standards too. The rise in US sales has meant that the US is now home to half of the twenty largest listed corporations globally (Table 1). Conversely, Europe and Japan, despite being the third and fourth largest economies of the world, respectively, together account for only three names on this list. Notably however, Emerging Markets have managed to punch above their weight and are home to six of the top twenty firms by sales globally. Table 1The US Today Dominates The Global List Of Top 20 Firms By Revenue What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The steep rise in America’s sales in the post-GFC world is also unique because no other major market has experienced such a clear upward move in sales as the US has. Europe and Japan in fact saw their sales-per-share trend downwards in the post-GFC period (Chart 14 and Chart 15). Emerging markets  were the only other major global market where sales-per-share managed to stay steady relative to the global benchmark (Chart 16). Chart 14Europe’s Sales Have Trended Lower Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 15Japan’s Sales Also Trended Lower Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Finally, thanks to the high growth in US sales, the contribution of sales to US equity prices is far higher than the contribution of its net profit margins or its price-to-earnings ratio (Chart 17). This once again is in sharp contrast to a market like Europe, where only a smidgeon of the European equity prices pie can be attributed to its sales. Chart 16EM Sales Have Expanded Marginally Post-2008 What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 17The Main Engine That Powers US Markets Is ‘Sales’ What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 18US Profit Margins Have Also Been Expanding Steadily Post-GFC What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Distinct from the role played by growing sales, the US’ stellar post-GFC performance has also been powered by growing profit margins. It is notable that the US has experienced an unusually strong upward movement in its profit margins in the post-GFC period (Chart 18). Japan is the only other region which has seen its profit margins expand post-GFC, with both Europe and EM having experienced a fall in profit margins from the levels seen in 2008. A Quick Note On Dividends: The US Lags On Dividend Yields But Leads On Buybacks Thus far we have focused on the returns generated by the US market relative to the world and the factors that drove US outperformance since the GFC. If one were to focus on the dividend yield component, then it is notable that the US lags its peers on this front. Post-GFC, the first major cresting of dividend yields globally took place in 2009-10. Then the next major move down in yields took place in 2020 (Chart 19). While globally, yields have now recovered from this last dip, the US finds itself lagging on this metric which matters for pension funds that rely on annuities (Chart 20). Not only have dividend yields in the US almost halved since the GFC, but the gap between dividend yields offered by the US and other markets has widened over the last few years. Europe however has managed to stay the undisputed leader when it comes to dividend yields through most of the 21st century. Chart 19Global Dividend Yields Have Recovered From The Post-2020 Fall What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 20US Lags Global Markets On Dividend Yields What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 21Pace Of Buybacks In The US Has Been Meaningful Pace Of Buybacks In The US Has Been Meaningful Pace Of Buybacks In The US Has Been Meaningful Notably, however, while the US lags its peers on dividend yields, it leads when it comes to buybacks. The latter is evident from the fact that proxy measures of shares outstanding have trended lower in the US in the post-GFC period, as compared to the rest of the world (Chart 21). Finally, it is important to note that both the growth in dividends-per-share as well as the absolute level of dividends in the US has been high. This parameter has increased by 2.4 times since 2008 and US dividends in absolute terms are nearly 5 times that of Europe’s dividends today. The only reason why dividend yields have stayed low despite this is because US equity prices have had a stellar run in the post-GFC period.     Can This Extent Of US Outperformance Persist? Having delved into the drivers of the US’ performance, we now know that a record expansion in sales and net profit margins have driven its outstanding performance in the post-GFC era. This in turn means that the probability of the US continuing to outperform over the next few years will be closely linked to its ability to maintain a lead on these two parameters. So how is the US positioned with respect to both these factors?   The US’ High Profit Margins Appear Unsustainable, For A Wide Range Of Reasons We have established the fact that expanding profit margins have been a supporting driver of the US’ outperformance in the post-GFC period. Now, the consensus view is that US profit margins are extraordinarily high and that they will eventually come down to earth. The logic for this argument is often grounded in mean reversion. We have also previously highlighted that most of the increase in US profit margins has occurred due to rising margins within the tech sector and the accompanying increase in the market cap weight of tech within benchmark indices. Chart 22US High Profit Margins Are Concentrated Amongst Top Firms What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Aside from these reasons, two more factors could lead to the compression of US profit margins over the next few years. Firstly, it is worth noting that the US' high profit margins are unusually concentrated amongst a handful of firms. While the US as a market is characterized by high margins at the headline level, profit margins of companies below the top tier are notably lower than that of the top tier (Chart 22). If profit margins were uniformly high across the US listed space and the divergence was low, then the probability of sustaining elevated margins would have been higher. But given that the US uniquely suffers from a high profit margin concentration problem, the probability of the sustainability of US high profit margins appears lower. Secondly, history suggests that in the globalized world that we live in, any region’s profit margins fail to persist above the global average beyond a maximum of 15 years (Table 2). This makes sense and is in line with economic theory which suggests that when profitability in a particular market is excessive, then new firms will enter this space, increase competition, and thereby exert downward pressure on the incumbents’ profit margins. Table 2Regional Profit Margins Seldom Persist Above The Global Average Beyond 15 Years What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Given that US profit margins have now persisted above global levels for almost 13 years, if history were to repeat itself, then it appears highly likely that US profit margins would trend towards the global average over the next 2 years.   US Sales Growth: A Peak Appears Nigh We now know that the rapid sales expansion experienced by US firms has been the prime driver of the US stock market outperformance since the GFC. However, the prognosis for this variable also appears shaky for the US. Chart 23US GDP And Sales Tend To Move In Lockstep What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? The key macro variable which has the tightest theoretical link to the sales generated by the companies in a country is the country’s nominal GDP. Even as companies headquartered in the US end up selling to the global economy, history suggests that the link between the US’ nominal GDP and the sales generated by listed American firms are closely linked (Chart 23). Given that the pace of US nominal GDP growth is set to slow over the next few years (relative to both its past and relative to other major economies), US companies’ sales growth could end up slowing too (Chart 24). Also, given that the US revenue-to-nominal GDP ratio is already elevated, it is likely that even as the US’ nominal GDP keeps growing, the pace of conversion of this GDP into revenues will stay the same or may even diminish over the coming decade.   Chart 24US GDP Growth Is Set To Slow What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Then from a bottom-up perspective, we are also of the view that the US economy’s ability to spawn mega-sized companies (by sales) may become increasingly compromised over the next decade. This is because a peculiar stagnation is in the works in the middle tier of American firms, which tend to become the mega-sized corporations of tomorrow. Finally, the US' antitrust philosophy is likely to undergo a once-in-a-generation change under the Biden administration. This could mean that America’s mega-scaled firms (which have had a free run up until now) could end-up baiting regulatory attention, restricting their ability to grow sales.   US Price Performance: Strong Sector Effects Are Unlikely To Persist Chart 25Sector Composition Effect: Strongest For The US What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Lastly, it is worth noting that the price performance of the broad US equity index subverts the role played by “sector composition” in driving the US' outperformance. The fact that returns generated by the US benchmark are higher than the returns generated by a hypothetical US index which weights all sectors equally suggests that “sector composition” effects had a meaningful role in driving US outperformance. In fact, as compared to other major markets, the sector composition effect is the most prominent for the US (Chart 25). Another way of quantifying the role of sector effects is to compare the US’ market cap expansion relative to a global benchmark after removing the market cap of top-performing sectors. Expectedly, US outperformance relative to the global benchmark over the post-GFC period gets substantially reduced if the market cap of the three top-performing sectors (namely Information Technology, Consumer Discretionary, and Health Care) is adjusted for (Chart 26). To complicate matters, the sector composition effect in the US has been unwinding but remains high (Chart 27). Given that we expect outperforming sectors like Tech to turn into underperformers, the sector constitution effect in the US could weaken going forward, thereby subverting another source of US outperformance.  Chart 26Extent Of US Outperformance Weakens Sans Tech, Consumer Discretionary, And Health Care What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Chart 27Sector Composition Effect In The US Remains High What Has Driven US Outperformance Post-GFC And Can This Persist? What Has Driven US Outperformance Post-GFC And Can This Persist? Investment Conclusions The prime drivers of US outperformance relative to the global benchmark in the post-GFC period have been ascendant sales and rising net profit margins. Forecasting is a tenuous science but given that both these propellers of the US equity market engine are set to face headwinds, investors should consider reducing allocations to US equities over a longer term, strategic horizon. Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com  

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 Neutral Rates Around The World Neutral Rates Around The World 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 Rising Global Inflation Rising 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 Neutral Rates Around The World Neutral Rates Around The World 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's Dissociated Real Rates Japan'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 Massive Real Estates Bubbles Massive 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 Rapidly Rising Debt Loads Rapidly 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 Neutral Rates Around The World Neutral Rates Around The World 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 R-star and Global Growth R-star and Global Growth Chart 6A Capex Revival? A Capex Revival? A 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 Neutral Rates Around The World Neutral Rates Around The World 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 Neutral Rates Around The World Neutral Rates Around The World Chart 9The US Fares Better The US Fares Better The US Fares Better Chart 10Easy Or Not? Easy Or Not? Easy 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 Big ECB Revisions Big 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 Neutral Rates Around The World Neutral Rates Around The World 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.

A message for Foreign Exchange Strategy clients, There will be no report next week, as we take a summer break. We will be joining our clients and colleagues for our annual investment conference to be held in New York, on September 7 & 8. We will resume our publication the following week, with a Special Report on the Hong Kong dollar, together with our China Investment Strategy colleagues. Looking forward to seeing many of you in person. Kind regards, Chester Ntonifor, Foreign Exchange Strategist Executive Summary No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy The biggest medium-term threat for Japan remains deflation, rather than inflation. This suggests that the BoJ will be loathe to abandon yield curve control anytime soon. That said, inflation is still accelerating globally, and has meaningfully picked up in Japan. Betting on a hawkish BoJ policy shift could therefore be a significant macro trade. We have identified five conditions that need to be met for the BoJ to begin removing accommodation. None are currently indicating an imminent need to alter monetary policy settings, particularly with the Japanese economy softening alongside subdued inflation expectations. The yen will soar on any hawkish BoJ policy shift. Currently, BCA Foreign Exchange Strategy is short EUR/JPY. That said, the historical evidence suggests waiting for an exhaustion in yen selling pressure, before placing fresh bets on selling USD/JPY. Longer-term bond yields in Japan, for maturities beyond the BoJ yield target, are already moving higher, while speculative interest in shorting JGBs has increased.  We recommend fading these trends for now – shorting JGBs outright will remain a “widowmaker trade”. Bottom Line: The yen has undershot and longer-term investors should buy it - our preferred way to express that view in the near-term is to be short EUR/JPY.  Bond investors should be underweight “low-beta” JGBs in fixed-income portfolios on a tactical basis, not as a hawkish BoJ bet, but because global bond yields are more likely to stay in broad trading ranges than break to new highs. Feature Chart 1The BoJ Is A Lonesome Dove When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? Almost every G10 central bank has raised rates over the last 12 months, even the perennially dovish banks like the ECB and Swiss National Bank, in response to soaring inflation.  The one exception has been the Bank of Japan (BoJ). The BoJ has kept policy rates unchanged throughout the year (Chart 1), while also maintaining its Yield Curve Control policy of capping 10-year Japanese government bond (JGB) yields at 0.25%. There has been interest from the macro investor community on Japan in recent months, betting on the BoJ eventually succumbing to the global monetary tightening trend.  If the BoJ were to shift gears and turn less accommodative, then the yen would surely soar, while JGBs will go on a fire sale. In this report, jointly published by BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy, we explore the necessary conditions that need to be in place for the BoJ to meaningfully shift policy, most likely starting with the end of Yield Curve Control before interest rate hikes. We see five such conditions, which will form a “checklist” to be monitored in the months ahead. Condition 1: Overshooting Inflation Expectations The BoJ has a policy mandate on inflation and most measures of underlying Japanese inflation are still well below its 2% target. For example, the weighted median and mode CPI inflation rates are only at 0.5%, even as headline CPI inflation has climbed to 2.6% on the back of two primarily non-domestic factors – rapidly rising prices for energy and goods (Chart 2). With such low baseline inflation, it has been hard to lift market-based Japanese inflation expectations like CPI swap rates above 1%, even as far out as ten years (Chart 3). CPI swaps have tended to provide a more realistic assessment of underlying Japanese inflation, adhering more closely to trends in realized core CPI inflation, and thus deserve the most attention from the BoJ.  This is in stark contrast to the BoJ’s own consumer survey of inflation expectations, that has consistently overestimated inflation over the years, which is currently showing both 1-year-ahead and 5-year-ahead inflation expectations at a startling, yet highly inaccurate, 5%.  Chart 2Low Underlying Inflation In Japan Low Underlying Inflation In Japan Low Underlying Inflation In Japan Chart 3No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan No Unmooring Of Inflation Expectations In Japan The BoJ is likely to side with the more subdued read on market-based inflation expectations in determining if monetary policy needs to turn less dovish – especially with the BoJ’s own estimate of the output gap now at -1.2%, indicating spare capacity in the economy and a lack of underlying inflation pressures (Chart 4). Chart 4Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Japan Still Suffers From Excess Capacity Condition 2: Excessive Yen Weakness Our more comprehensive measure of determining the pressure to change monetary policy is captured in our central bank monitor for Japan, a.k.a. the BoJ Monitor.  The Monitor includes economic, inflation and financial variables. This measure suggests that the BoJ should not be tightening monetary policy today (Chart 5). One of the variables that goes into our BoJ Monitor is the yen. The yen impacts monetary conditions through two ways. First, import prices tend to rise as the yen weakens, feeding into domestic inflation. In short, it eases monetary conditions. That has been the story over the last year with the yen falling -15% on a trade-weighted basis (Chart 6). The second impact is through profit translation effects. Overseas earnings for Japanese exporters are buffeted in yen terms as the currency depreciates. Both impacts would tend to put more pressure to tighten monetary policy, on the margin. Chart 5No Urgency To Tighten Policy No Urgency To Tighten Policy No Urgency To Tighten Policy Chart 6Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation Yen Weakness Only Generates Temporary Inflation However, the impact of yen weakness in boosting profit translation costs for Japanese concerns has eased over the years. As many Japanese companies have offshored production, lower wages in Japan have been offset by higher costs abroad. As a result, profit margins for multinational Japanese corporations are not rising meaningfully relative to their G10 peers, despite yen weakness (Chart 7). That puts the central bank in a quandary regarding how to interpret yen weakness vis-à-vis future policy moves. On the one hand, soaring global inflation and a weak yen should be allowing the BoJ to declare victory on rising inflation expectations in Japan. On the other hand, domestic wage growth will not reach “escape velocity” (Chart 8), and inflation will fail to overshoot on a sustainable basis, if corporate profit margins are not rising meaningfully. Chart 7No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness No Widespread Signs Of Increased Profitability From Yen Weakness Chart 8No Escape Velocity Yet In Japanese ##br##Wages No Escape Velocity Yet In Japanese Wages No Escape Velocity Yet In Japanese Wages Of course, Japanese authorities care about excessive moves in the yen, but they also understand their limited ability to alter the path of the currency. The Ministry of Finance last intervened to support the currency in 1998. That helped the yen temporarily, but global factors dictated its longer-term trend. A BoJ monetary tightening designed solely to stabilize the yen, before inflation expectations stabilize at the BoJ target, is a recipe for failure on both fronts. The bottom line is that yen weakness is giving a lift to inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year just to generate a one percentage point increase in Japanese inflation. As such, the current bout of yen weakness is unlikely to alter the longer-term goals of BoJ policy, unless a wave of selling undermines financial stability. Condition 3: Continually Rising Energy Costs Chart 9Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Japan Is More Energy Dependent Than Many Other Countries Policy makers in the eurozone have told us that even in the face of a recession, a threat to their credibility on price stability – like the energy-fueled overshoot of European inflation - is worth defending through monetary tightening. Thus, a continued external energy shock could also cause the BoJ to shift. Our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium on oil to increase in the near term. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 9). A rise in energy costs that unanchors inflation expectations is a threat worth monitoring for the BoJ, one that could drag it into monetary tightening as has been the case in Europe. That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent is likely to soften, assuaging energy import costs (Chart 10). Japan is also ramping up nuclear power production, which can help provide alternative sources to imported energy (Chart 11). Chart 10An Unprecedented Arbitrage An Unprecedented Arbitrage An Unprecedented Arbitrage Chart 11Nuclear Power Could Help? Nuclear Power Could Help? Nuclear Power Could Help? The BoJ would likely not consider an early exit from accommodative monetary policy based solely on energy-fueled inflation.  After all, the current surge in global energy prices, compounded by yen weakness, has barely pushed headline inflation above the BoJ 2% target – with little follow-through into core inflation or wage growth. Condition 4: An Economic Revival In Japan A burst in Japanese growth that absorbs excess capacity and tightens labor market conditions could convince the BoJ that a policy adjustment is due. This could result in higher Japanese interest rates and bond yields.  The yen also tends to appreciate when the Japanese economy is improving (Chart 12). Unfortunately, Japanese growth momentum is going in the wrong direction for that outcome. Chart 12The Yen And the Japanese Economy The Yen And the Japanese Economy The Yen And the Japanese Economy Domestic demand has been under siege from the lingering effects of the pandemic, including an unprecedented collapse in tourism. As the pandemic effects have faded, however, Japan’s economy faces new threats from slowing global growth, waning export demand, and declining consumer confidence (Chart 13). It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains nearly three percentage points below the level implied by its pre-pandemic trend. While Japan’s unemployment rate is 2.6% and falling, it remains above the low reached just before the start of the pandemic. Chart 13A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth A Broad-Based Slowing Of Japanese Growth What Japan needs now is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Stronger fiscal spending could lift animal spirits in Japan and cause the BoJ to shift. Yet even on that front, the evidence does not point to a direct link from fiscal stimulus to rising inflation expectations – a necessary catalyst for the BoJ to turn more hawkish. A recent study by the Federal Reserve Bank of San Francisco concluded that there was no boost to depressed Japanese inflation expectations from the massive Japanese government fiscal programs during the worst of the 2020 COVID-19 pandemic shock. Waning Japanese economic momentum is not putting any pressure on the BoJ to begin considering a shift to less accommodative monetary settings. Condition 5: More Hawkish Members At The BoJ There are important transitions occurring within the BoJ’s nine-member board that could change the policy bias in a less dovish direction.  In July, two new board members – Hajime Takata and Naoki Tamura – were appointed to the BoJ board. Both brought up the notion of the need for an “exit strategy” from current easy monetary policies at their introductory press conference, although both were also careful to state that they did not think the conditions were in place yet for that to occur. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? Nonetheless, the two new appointees represent a marginally hawkish shift in the policy bias of the BoJ board, especially Takata who replaced one of the more vocal advocates for maintaining aggressive monetary easing, economist Goushi Kataoka.  Of course, the big change at the top of the BoJ will come next April when Governor Haruhiko Kuroda’s current term ends. This will follow the departures of the two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe in March. That means five of nine board members would be changed in less than one year, including the most senior leadership. That would be a huge change for any central bank, but especially for the BoJ where Governor Kuroda has overseen the introduction of all the current aggressive monetary policies, from negative interest rates to massive quantitative easing to Yield Curve Control. A growing constraint for the future of Yield Curve Control As outlined earlier, underlying inflation and growth trends in Japan are nowhere close to justifying an end to Yield Curve Control or even a mere upward tweak of the current 0.25% yield target on 10-year JGBs. However, there are negative spillover effects from the BoJ’s bond market manipulation that could make the current policies less sustainable over the medium term for the new incoming BoJ leadership. We addressed one of those issues earlier with the extreme yen weakness, which is largely a product of the BoJ keeping a lid on Japanese interest rates while almost the entire rest of the world is in a monetary tightening cycle. But another issue to be addressed is the impaired liquidity of the JGB market. After years of steady, aggressive bond buying, the BoJ has essentially “cornered” the JGB market.  The central bank now owns roughly 50% of all outstanding JGBs, doubling its ownership share since Yield Curve Control started in 2016 (Chart 14).  The numbers are even more extreme when focusing on the specific maturity targeted by the BoJ under Yield Curve Control, with the central bank now owning nearly 80% of all 10-year JGBs (Chart 15). Chart 14The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market The BoJ Has Cornered The JGB Market Chart 15BoJ Now Owns 80% Of 10yr JGBs When Will The BoJ Abandon Yield Curve Control? When Will The BoJ Abandon Yield Curve Control? By absorbing so much supply of the main risk-free asset in the Japanese financial system, the BoJ has made life more difficult for Japanese commercial banks, insurance companies and pension funds that require JGBs for regulatory and risk management purposes. In the most recent BoJ survey of bond market participants, 68 of 69 firms surveyed described the JGB market as having poor liquidity conditions, with an equal amount stating that JGB trading conditions were as bad or worse than three months earlier. The change in BoJ leadership could also bring about a change in policymakers’ desire to continue manipulating the JGB market via Yield Curve Control.  Although the BoJ would have to be very careful in how it signals and executes any change to Yield Curve Control.  There is currently a very wide gap between a 10-year JGB yield at 0.25% and a 30-year JGB yield at 1.25% (Chart 16). If the BoJ completely ended Yield Curve Control, the 10-year yield would converge rapidly towards that 30-year yield, likely reaching 1%. That would create a major negative total return shock to the Japanese banks and institutional investors that still own nearly 40% of JGBs. Chart 1610yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control 10yr JGB Yields Will Surge Without Yield Curve Control A more likely outcome would be the BoJ raising the yield target on the 10-year to something like 0.50%, or perhaps shifting to a different maturity target where the BoJ owns a smaller share of outstanding JGBs like the 5-year sector. Yet without an actual trigger for such a move coming from faster economic growth or core inflation hitting the 2% BoJ target, it is highly unlikely that the BoJ would dare tinker with its yield curve policy, and risk a JGB market blowup, solely over concerns about bond market liquidity. Investment Conclusions None of the items in our newly constructed “BoJ Checklist” are currently indicating that a shift in Japanese monetary policy is imminent.  We therefore see it as being too early to put on the legendary “widowmaker trade” of shorting JGBs, although a case can be made to go long the yen based on longer-term valuation considerations. Japanese yen The carnage in the yen is in an apocalyptic phase, but the BoJ is unlikely to rescue the yen in the near term. As such, short-term traders should be on the sidelines. For longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 17). Meanwhile, according to our PPP models (and a wide variety of others), the Japanese yen is the cheapest G10 currency, undervalued by around -41% (Chart 18). BCA Foreign Exchange Strategy is currently long the yen versus the euro and the Swiss franc. Chart 17The Yen Is On Sale The Yen Is On Sale The Yen Is On Sale Chart 18The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap JGBs Chart 19Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs Stay Tactically Underweight JGBs In the absence of a bearish domestic monetary policy trigger, JGBs should be treated by global bond investors as a risk management tool as much as anything else. The relative return performance of JGBs versus the Bloomberg Global Treasury Index of government bonds is highly correlated to the momentum of global bond yields (Chart 19). Thus, increasing the exposure to JGBs in a global bond portfolio is akin to reducing the interest rate duration of a bond portfolio – both positions will help a portfolio outperform its benchmark when global bond yields rise. On a tactical basis (3-6 month time horizon), an underweight allocation to JGBs in government bond portfolios seems appropriate, even with JGBs offering relatively attractive yields on a currency-hedged basis, most notably for USD-based investors.  Global bond yields are more likely to stay in broad trading ranges, capped by slowing global growth and decelerating goods inflation but floored by stickier non-goods inflation and hawkish central banks. Thus, the defensive properties of JGBs as a “duration hedge” in global bond portfolios are less necessary in the near-term. Beyond the tactical time horizon, the uncertainty over the potential makeup of new BoJ leadership in 2023, along with some easing of global inflation pressures from the commodity space, could justify lower JGB exposure on a more structural basis - if it appears that a new wave of more hawkish policymakers is set to take over in Tokyo. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary