Australia
As expected, the Reserve Bank of Australia lifted the Cash Rate target by 50bps to 1.35% on Tuesday, marking the second consecutive jumbo rate hike. The latest increase brings the cumulative magnitude of rate hikes since the beginning of the tightening cycle…
Executive Summary China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question. Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar
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Listen to a short summary of this report. Executive Summary US Financial Conditions Have Tightened Significantly This Year US financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations. If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the US and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. Stay overweight stocks, favoring non-US equities over their US peers. We are closing our short 10-year Gilts trade, initiated at a yield of 0.85%, for a gain of 7.5%. We are also opening a new trade going long Canadian short-term interest rate futures versus their US counterparts. Investors expect Canadian rates to exceed US rates in 2024, which seems unlikely to us given that the Canadian housing market is much more sensitive to higher rates than the US market. Bottom Line: After having tightened significantly over the past seven months, financial conditions should loosen modestly during the remainder of the year. This should benefit risk assets. Fed Focused on Financial Conditions Chart 1Tighter Financial Conditions Will Hurt Growth Like many central banks, the Fed sees financial conditions as a key driver of the real economy. While there are many financial conditions indices (FCIs), most include bond yields, credit spreads, equity prices, and the exchange rate as inputs. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa. Goldman’s US FCI is especially popular among market participants. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the historic relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below-trend pace by the second quarter of 2023. In fact, the tightening in the Goldman FCI over the past 12 months already suggests that the manufacturing ISM will fall below 50 (Chart 1). Along the same lines, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved slightly into restrictive territory. Aside from a brief period at the outset of the pandemic, the index has been consistently in expansionary territory since early 2013 (Chart 2). Chart 2The Chicago Fed Financial Conditions Index Has Moved Into Slightly Restrictive Territory Other data are consistent with the message from the FCIs. Most notably, growth estimates for the US and for other major economies have come down over the past few months (Chart 3). Economic surprise indices have also fallen, especially in the US. Chart 3AGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Chart 3BGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Mission Accomplished? Chart 4The Fed Expects To Lift Rates Above Its Estimate Of Neutral Given the recent tightening in financial conditions and weaker growth expectations, the Fed is likely to soften its tone. Already this week, Atlanta Fed President Raphael Bostic suggested that the Fed could pause raising rates in September in order to assess the impact of the Fed’s tightening campaign. The Fed minutes also conveyed a sense of flexibility and data-dependence about the timing and magnitude of future hikes once rates reach 2%. It’s worth stressing that the Fed expects rates to rise in 2023 to about 40 bps above its estimate of the terminal rate (Chart 4). Jawboning rate expectations higher would potentially undermine the Fed’s goal of achieving a soft landing for the economy. Inflation Will Dictate How Much Easing Lies Ahead There is a big difference between not wanting financial conditions to tighten further and wanting them to loosen. The Fed would only want to see an easing in financial conditions if inflation were to fall faster than expected. Chart 5 shows how the year-over-year change in the core PCE deflator would evolve over the remainder of the year depending on different assumptions about the month-over-month change in the deflator. The Fed would be able to reach its expectation of year-over-year core PCE inflation of 4.1% for end-2022 if the month-over-month change averages 0.33%. Monthly core PCE inflation averaged 0.3% in February and March and is expected to clock in at around the same level for April once the data is released tomorrow. Chart 5AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) Chart 5BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) Regardless of tomorrow’s data print, as we discussed last week, we expect the monthly inflation rate to average less than 0.3 in the back half of the year. If that happens, inflation will surprise to the downside relative to the Fed’s expectations. Consistent with the observation above, market-based inflation expectations have already declined. The 5-year TIPS inflation breakeven has fallen from 3.64% in March to 2.98% at present. The widely watched 5-year/5-year forward breakeven rate is back down to 2.29%, at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 6).1 The Citi US Inflation Surprise Index has also rolled over (Chart 7). Chart 6Market-Based Inflation Expectations Have Come Down Of Late Chart 7The US Inflation Surprise Index Has Rolled Over Financial Conditions Abroad Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar (Chart 8). Nevertheless, with growth momentum having already deteriorated sharply, central banks are signaling a more balanced approach towards policy normalization. Chart 8Financial Conditions Have Tightened More In The US Than Elsewhere This Year ECB: Wait and See? In a blog post published on Monday, Christine Lagarde observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than they were two years ago. In her mind, this warrants ending net purchases under the Asset Purchase Programme early in the third quarter. It also warrants raising the deposit rate by 25 bps at both the July and September meetings, bringing it back to zero from -0.5% at present. Beyond then, Lagarde was circumspect about what should be done, stressing the need for “gradualism, optionality and flexibility.” She noted that “The euro area is clearly not facing a typical situation of excess aggregate demand or economic overheating … Both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends.” She then added: “The outlook is now being clouded by the negative supply shocks hitting the economy … households’ expectations of their future financial situation dropped to their second-lowest level on record in March and remained close to that level in April.” The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023 (Chart 9). BCA’s Global Fixed Income team, led by Rob Robis, foresees only 50 bps of tightening over the next 12 months. Chart 9Markets Expect Rates To Rise The Most In The Anglo-Saxon World The UK, Canada, and Australia: Frothy Housing Markets Will Limit Rate Hikes The Bank of England (BoE) hiked rates by 90 bps over the past 12 months. The UK OIS curve is priced for another 140 bps of rate hikes over the next year. According to the BoE’s forecasting models, this would raise the unemployment rate by two percentage points while lowering inflation to below 2% within the next two-to-three years. In our opinion, that is more tightening than the BoE would like to see. BCA’s strategists expect the BoE to deliver only another 75 bps of hikes over the next year. Chart 10Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries The Canadian economy has been quite strong, with the unemployment rate falling to 5.2% in April, the lowest since 1974. The Canadian OIS curve is discounting 195 bps of interest rate hikes over the next 12 months, substantially more than the 150 bps of tightening our fixed income team foresees. By mid-2024, investors expect Canadian policy rates to be about 25 bps above US rates. This seems unreasonable to us, and as of this week, we are expressing this view by going long the June 2024 3-month Canadian Bankers’ Acceptance (BAX) futures contract (BAM4) versus the corresponding 3-month US SOFR futures contract (SFRM4). A more liquid option is to simply go long the 10-year Canadian government bond versus the 10-year US Treasury note. At present, Canadian 10-year government bonds are yielding 5 bps more than their US counterparts. Unlike in the US, where household debt has fallen over the past 14 years, debt in Canada has risen, fueled by a massive housing boom (Chart 10). High indebtedness and the prevalence of variable rate/short-term fixed-rate mortgages will limit the ability of the BoC to raise rates. The Australian OIS curve is currently discounting 262 bps of rate hikes over the next year which, if realized, would take the cash rate to 3.3% – a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. BCA’s fixed income strategists expect only 150 bps of tightening over the next 12 months. Japan: Yield Curve Control Will Continue Chart 11Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World The Bank of Japan expects inflation excluding fresh food prices to remain at about 2% in the second half of 2022, but then to slow to 1.1% in the fiscal year starting April 2023. The Japan OIS curve is discounting almost no tightening over the next 12 months. Long-term inflation expectations are far lower in Japan than in any other major economy, which makes ultra-low rates a necessity for the foreseeable future (Chart 11). China: Outright Easing Chart 12Covid Restrictions Have Eased Only Modestly In China China faces a trifecta of problems: A weakening housing market; slowing external demand for manufactured goods; and the ongoing threat of Covid-related lockdowns. Despite a steep drop in the number of new Covid cases over the past month, China’s lockdown index has only eased modestly, as the authorities continue to fret about the next outbreak (Chart 12). The leadership in Beijing has responded with policy easing. The PBoC lowered the 5-year loan prime rate by 15 bps last week, the largest such cut since 2019. This followed a cut in the floor rate for first-home mortgages that was announced on May 15. BCA’s China strategists believe these measures will arrest the deep contraction in the property market but will not spark a full-blown recovery due to the ongoing commitment of the government to the “three red lines” policy.2 In normal times, a Chinese real estate slump would be a cause of grave concern for global investors. These are not normal times, however. Public enemy number one these days is inflation. A weaker Chinese property market would curb commodity demand, thus helping to cool inflation. That would be a welcome development for global investors. Investment Conclusions Global financial conditions have tightened to the point that betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric. We took partial profits on our short 10-year Treasury trade earlier this month (initiated at a yield of 1.45%). As of this week, consistent with the earlier decision of BCA’s fixed income strategists to upgrade UK Gilts, we are closing our short 10-year Gilt position (initiated at a yield of 0.85%) for a gain of 7.5%. The coming Goldilocks environment of falling inflation and supply-side led growth will buttress equities. We expect global stocks to rise 15%-to-20% over the next 12 months, with non-US markets outperforming the US. Looking further out, the fate of Goldilocks will rest on where the neutral rate of interest resides. If the neutral rate in the US turns out to be substantially lower than 2.5%, then any growth recovery will falter as the lagged effects of restrictive monetary policy work their way through the economy. Conversely, if the neutral rate turns out to be substantially higher than 2.5%, then inflation will reaccelerate as the economy overheats. Given the choice, we would wager on the latter outcome. Thus, while we expect global bond yields to decline over a 12-month horizon, we foresee them rising over a 2-to-5-year time frame. Similarly, while stocks will strengthen over the next 12 months, they are likely to encounter another bout of turbulence starting late next year or in 2024 as central banks initiate a second round of rate hikes. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2 The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Executive Summary Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers Chart 2Markets Expect Very Aggressive RBA Tightening The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate Chart 5The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment Chart 9Headwinds For The Australian Consumer The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus Chart 12Canada Offers Clue To Size Of Australian Stimulus Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade Chart 14The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming Chart 16Australia Is Resource Superstar Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com
Listen to a short summary of this report. Executive Summary EUR/JPY And The DXY: Unsustainable Gap Three interrelated themes are likely to play out by the end of 2022 – peak Fed hawkishness, continued central bank convergence, and nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet through a short EUR/JPY trade, a corresponding play on the second theme. Betting on nascent green shoots in economic growth can be expressed via a long Aussie position, or more prudently, a short CHF/SEK bet. We are long a CAD and NOK basket against the RUB, a play on an eventual recovery in oil demand, and the premium that these blends will continue to command relative to Russian oil. Finally, most of our trades remain at the crosses due to elevated FX volatility which has boosted safe-haven demand for the dollar. The admission of Sweden and Finland into NATO could increases the risk of miscalculation on the part of Russia, which will continue to prop near-term safe-haven demand for the dollar. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 133.28 2022-05-12 -0.73 Bottom Line: Continue to focus on relative value trades at the crosses, until signs emerge that FX volatility is peaking, which will be more conducive for direct USD bets. Feature Chart 1Dollar Capitulation Occurs At Record Valuation And A Record Deficit Last week’s report focused on the key reasons why longer-term investors should begin to fade dollar strength. For one, the dollar already imbeds a hefty safe-haven premium. This premium manifests itself in an overvalued exchange rate (Chart 1). A simple PPP model shows that the dollar is overvalued by 27%. This is higher than the peak in the US dollar which preceded the bear market that began in the early 2000s. While valuations tend to matter little until they trigger a tipping point, such an inflection point could be around the corner. One catalyst has been the widening trade deficit which needs to be financed via foreign capital inflows. The US trade deficit continues to deteriorate, hitting a record low of $109.8bn in March. Over the last few years, it has become increasingly difficult to fund this widening trade deficit through foreign purchases of US Treasuries. That said, FX markets are likely to focus on three interrelated themes in the near term – peak Fed hawkishness, continued central bank convergence, and the potential for nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet with a short EUR/JPY trade, a corresponding play on the second theme. In the next few sections, we go through a few trades that would benefit from these themes. Short EUR/JPY: A Defensive Play Most of our trades in the portfolio are pro-risk. As such, a short EUR/JPY position acts as an attractive hedge in the near term. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate, but an unusually wide gap has opened up (Chart 2). In our view, this suggests that the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, as we witnessed on Wednesday, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that this cross is stretched on a longer-term time horizon. First, the cross is expensive on a PPP basis. Chart 3 shows that EUR/JPY usually peaks when the real effective exchange rate is 1.5 standard deviations above its long-term mean. Today’s valuation pins it close to that, among the highest levels since the 1980s. Standard economic theory suggests that a reversal in the cross will be warranted to realign euro area competitiveness relative to Japan. Chart 2EUR/JPY And The DXY: Unsustainable Gap Chart 3EUR/JPY Is Not Cheap Meanwhile, there is a case to be made that an expensive EUR/JPY exchange rate is already affecting relative competitiveness. European exports are relapsing relative to those in Japan, which usually ensues after a period of euro-yen strength. Case in point: German factory orders are already contracting, while machinery orders in Japan remain relatively robust (Chart 4). Second, the European Central Bank has been relatively hawkish, vis-à-vis the Bank of Japan. The yield on December 2022 Euribor contracts is 78bps above the TIBOR equivalent, suggesting the ECB will hike rates 4-5 times this year versus the BoJ. Granted, inflation is overshooting in Europe relative to Japan (Chart 5). But as we have been witnessing around the world from the UK to Canada, and all the way to Australia, rising inflation is a global problem. If it persists, it will also begin to meaningfully show up in the Japanese numbers. This will nudge the BoJ away from the ultra-dovish camp. More likely, inflation will moderate, which will allow the ECB to dial back its hawkish rhetoric. Chart 4Europe Is Losing Competitiveness To Japan Chart 5Eurozone Inflation Could Subside In The Coming Months Even if inflation moderates in the eurozone, short-term real rates will remain deeply negative compared to Japan. This will be a significant drag for relative fixed income flows and the currency (Chart 6). At the same time, higher inflation in Europe also suggests the fair value for EUR/JPY should continue its structural downtrend. Chart 6Real Rates Are Very Low In The Eurozone Third, oil price volatility will remain high in the near term but will subside longer term. We are cognizant of the fact that, our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium in oil to increase in the near term. When rising oil coincides with rebounding economic activity, the yen tends to lag as a defensive currency (Chart 7). This time around, the premium in energy markets has come from a cutoff in Russian supplies. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 8). This has boosted EUR/JPY and is a risk to a short position. Chart 7EUR/JPY Tracks Oil Chart 8Japan Will Accelerate A Shift From Fossil Fuels 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 are collapsing (Chart 9). The Japanese have already ramped up nuclear power production, reducing their dependence on fossil fuels (Chart 10). That will be a welcome fillip for the Japanese trade balance. In a nutshell, a lot of bad news is already priced in the yen. As such, it has become an attractive hedge. Asian clients not willing to short the euro can short CNY/JPY as a close proxy. Interestingly, CNY/JPY has made a classic double-top and could meaningfully depreciate from current levels (Chart 11), along with EUR/JPY. Chart 9The European And Asian Natgas Premium Is Deflating Chart 10A Nuclear Renaissance In Japan? Chart 11CNY/JPY: A Double Top? Short CHF/JPY: Still Attractive, But Taking Profits We also played a long yen leg via a short CHF position but our trailing stop was triggered this week at 130 for a profit of 3.74%. While we believe the cross still faces meaningful downside, we will opportunistically look to sell CHF/JPY again at 135. First, historically, CHF/JPY has inversely tracked the inflation profiles between Switzerland and Japan. Given the collapse in the yen, and much higher Swiss inflation, CHF/JPY has become incrementally more expensive, especially relative to history (Chart 12). To realign competitiveness, the cross should depreciate. Second, from a technical perspective, CHF/JPY is in a classic double-top formation (Chart 13), akin to CNY/JPY. This suggests the safe-haven premium is much higher in the franc than it is in the yen. Chart 12Swiss Inflation Is Lowering CHF"s Puchasing Power Chart 13CHF/JPY: Look To Go Short Again The key risk to this trade is that the Swiss equity market is more defensive relative to Japanese bourses. As such, the hefty safe-haven premium in the franc could persist (Chart 14), pushing the cross to our initial entry short point at 135. Chart 14Swiss Equities Could See Inflows Near Term Short CHF/SEK: A Play On The Riksbank’s U-Turn Chart 15Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Last month, we argued that the dip in the Swedish krona had already priced a recession in the domestic economy. Meanwhile, with a mandate of price stability, we argued the Riksbank will have no choice but to turn more hawkish or lose credibility. As a play on this trend, we recommended going long the SEK relative to the CHF. In a major policy U-turn, the Riksbank raised rates and announced a faster pace of balance-sheet reduction. Most of the arguments made in the original report remain valid, so we will not revisit them here. The one point we will stress is that Sweden’s small open economy makes the SEK very sensitive to global economic conditions. One benefit of a short CHF/SEK position is that while value has been outperforming growth during this selloff, CHF/SEK remains strong which is a departure from the traditional relationship (Chart 15). Ergo, a major safety discount is imbedded in the SEK. Related Report Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar Sweden’s bourse is heavy in cyclicals, with large overweight positions in financials and industrials, that will benefit from a renewed capital spending cycle, and higher global rates. Meanwhile, the outperformance of value during a market riot point suggests a change in market leadership could be underway, even if bond yields temporarily crater. The krona remains vulnerable to geopolitical risk, especially if Russia retaliates against Sweden and Finland joining NATO. So far, Russia’s response has been muted. As such, while this pro-cyclical trade faces near-term risk, it remains a safer way, in our view, to play SEK strength. Long AUD: Bet On An Eventual China Rebound Chart 16The AUD And China We will be discussing Australia in an in-depth report next week, so we will keep our comments brief this week. What we will say is that the Aussie is one of the best candidates to play a rebound in global growth, given that it sits near the epicenter of where that growth will likely emanate from – China (Chart 16). Right now, the picture is not pretty, but it is always dark before dawn. Stay tuned. Long (CAD+NOK)/RUB: A Relative Value Play As many countries reroute their oil supplies from Russia to other countries, Canada and Norway could stand to benefit from a relative perspective. Understandably, many clients might not be able to trade the RUB, so we are filing this trade under speculative. First, both Brent and Western Canadian Select oil are trading at a significant premium to the Urals blend, which is likely to be sustained in the next 6 months. This will benefit NOK and CAD, relative to the ruble (Chart 17). Chart 17CAD And NOK Will Benefit From Premium Oil Second, from an FX point of view, Russia faces the trilemma of the impossible trinity – having decided to limit the free flow of capital, it has chosen independent monetary policy and managing the exchange rate. This will come at a cost, however: As the economy comes grinding to a halt and inflation surges, interest rates will have to stay high to maintain currency stability. This will crush the domestic economy for years to come. Luckily, Russia has a healthy current account surplus, but as production in Canada and Norway improve to offset embargoes on Russian crude, this will also boost their external balance. Long EUR/GBP: The Euro Is More Priced For A Recession We have discussed at length the rationale behind our long EUR/GBP position, so we will not reiterate the arguments here. Our Global Fixed Income colleagues upgraded Gilts to overweight last week, in line with expectations that markets will continue pricing a dovish tilt from the BoE. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. As such, if interest rates in the UK continue to fall relative to those in the eurozone, EUR/GBP will benefit (Chart 18). Chart 18EUR/GBP Has Upside Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Wages in Australia rose 2.4% y/y (0.7% q/q) in Q1, slightly below expectations of 2.5% y/y (0.8% q/q). Administrative & support services, education & training as well as arts & recreational services industries drove wage growth over the quarter.…
Executive Summary Global inflation will peak sometime in the next few months, a process that has likely already begun in the US. This will give policymakers some breathing room to turn less hawkish, a more credible stance given softening global growth momentum and increased financial market volatility. Our Global Golden Rule of Bond Investing suggests that overall government bond returns should turn positive over the next year, but with widening divergences across countries for our base case scenarios. Projected government bond return expectations over the next 12 months look most attractive in Australia, Germany and the UK – where far too many rate hikes are priced in – compared to the US, where the Fed is more likely to follow through on most, but not all, discounted rate increases. Japan has the lowest expected returns, and the defensive properties of “low-beta” JGBs will be less necessary with global yield momentum set to peak in the latter half of 2022. Our Global Golden Rule Base Case Scenarios For The Next 12 Months Bottom Line: The return expectations over the next year stemming from our Global Golden Rule suggest the following country allocation recommendations in global government bond portfolios: maintain overweights in Australia, Germany and the UK, stay underweight the US and neutral Canada, but downgrade Japan to underweight. Feature Chart 1A Pause In The Global Bond Bear Market Global bond markets may finally be showing signs of settling down after a painful period of rising yields and high volatility. Government bond yields across the developed economies have fallen substantially over the past week as equity and credit markets have sold off, in a typical risk-off response to increased concerns over global growth momentum. For example, benchmark 10-year government yields have fallen by -32bps both the US and UK, -25bps in Germany and -22bps in Canada since the cyclical intraday high was reached on May 9. These moves are modest in the context of the cyclical bond bear market, with the Bloomberg Global Treasury index still down -12.1% year-to-date and -14.4% on a year-over-year basis (Chart 1). That painful selloff has been driven by expectations of intense monetary tightening in response to surging global inflation. However, last week’s release of US Consumer Price Index data for April confirmed that US goods inflation has peaked, a trend that we expect to follow suit in other countries (Chart 2). That will leave inflation momentum, and eventual interest rate hikes, to be driven more by domestic services inflation that will prove to be less correlated across countries over the next 6-12 months (Chart 3). Chart 2Inflation & Rate Hike Expectations Have Become Correlated. . . Chart 3. . .Making Our Global Golden Rule All About Inflation With that in mind, we revisit our framework for linking government bond returns to monetary policy outcomes versus expectations, the Global Golden Rule of Bond Investing. A Brief Overview Of The Global Golden Rule In September 2018, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.” This was an extension of a framework introduced by our sister service, US Bond Strategy, that links US Treasury returns (versus cash) to changes in the fed funds rate that were not already discounted in the US Overnight Index Swap (OIS) curve.1 The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields and Treasury returns. Related Report Global Fixed Income StrategyRevisiting Our Global Golden Rule Of Bond Investing We discovered that relationship also held in other developed market countries. This gave us a framework to help project expected global bond returns simply based on a view for future central bank interest rate moves versus market expectations.2 Specific details on the calculation of the Global Golden Rule can be found in those original 2018 papers. In the following pages, we present the latest results of the Global Golden Rule for the US, Canada, Australia, the UK, the euro area and Japan. The set-up for the chart shown for each country is the same. We show the 12-month policy rate “surprise”, defined as the actual change in the central bank policy rate over the preceding 12-months versus the expected 12-month change in the policy rate from a year earlier extracted from OIS curves (a.k.a. our 12-month discounters). We then compare the 12-month policy rate surprise to the annual excess return over cash (treasury bills) of the Bloomberg government bond index for each country. We also show the 12-month policy rate surprise versus the 12-month change in the government bond index yield. The very strong historical correlation between those latter two series is the backbone of the Global Golden Rule framework. After that, we present tables showing expected yield changes and excess returns for various maturity points, as well as the overall government bond index, derived from the Global Golden Rule regressions. The expected change in yield is derived from regressions on the policy rate surprises, with different estimations done for each maturity point. In the tables, we show the results for different scenarios for changes in policy rates. For example, the row in the return tables labeled “+25bps” would show the expected yield changes and excess returns if the central bank for that particular country lifts the policy interest rate by +25bps over the next 12 months. Showing these scenarios allows us to pick the one that most closely correlates to our own expectation for central bank actions, translating that into government bond return expectations. Global Golden Rule: US Chart 4Risk/Reward Favors Less UST-Bearish Fed'Surprises' US Treasuries have delivered a painful loss of -7.8% versus cash over 12 months. Bearish outcomes of such magnitude were last seen during 1994 and 1999 when the Fed was aggressively lifting the funds rate. The Fed delivered a smaller hawkish surprise over the past year than those 1990s episodes, with a trailing 12-month policy rate surprise of -72bps. Thus, the Golden Rule underestimated losses realized by US Treasuries, as US bond yields moved to price in far more Fed tightening than what was expected one year ago. The US OIS curve now discounts +229bps of rate hikes over the next 12 months, taking the fed funds rate to 3.3% (Chart 4). That is a more aggressive profile than was laid out in the March 2022 Fed “dots”, where the median FOMC member projection called for the funds rate to climb to 2.8% in 2023. That means there is less scope for Fed rate hikes to surprise versus market expectations that are already very hawkish, at a time when US growth and inflation momentum is rolling over. Our base case calls for the Fed to deliver +200bps of rate increases over the next year, +50bps at the next two policy meetings followed by +25bps at the subsequent four meetings. That outcome produces a Golden Rule forecast of the overall US Treasury index yield falling -13bps, generating a total return of +3.73% (Tables 1 & 2). Table 1US: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 2US: Expected Changes In Treasury Yields Over The Next 12 Months Global Golden Rule: Canada Chart 5Canadian Bonds Selloff After A Hawkish BoC Canadian government bonds have sold off hard over the past 12 months, delivering an excess return over cash of -7.5% (Chart 5). That loss reflects the Bank of Canada’s (BoC) hawkish turn, but is a less severe outcome compared to other developed economy government bond markets that saw a major repricing of rate hike expectations like the US and Australia. Losses in the Canadian government bond market were consistent with the +34bps of hawkish surprises delivered by the BoC, which tightened by +75bps on a 12-month basis versus the +41bps expected by markets in May 2021. Rate expectations are highly aggressive on a forward basis. The Canadian OIS curve now discounts 210bps of interest rate increases over the next 12 months. However, high household debt in Canada, fueled by a relentlessly expanding housing bubble, will limit the ability of the BoC to match the Fed’s rate hikes over the next 6-12 months. Higher debt levels also imply a lower nominal neutral rate of interest, as the BoC has less room to hike before debt servicing costs become overly burdensome for overleveraged Canadian consumers. Our base case is that the BoC will deliver +150bps of tightening over the next 12 months. This produces a Golden Rule forecast of a decline in the overall Canadian government bond index yield of -17bps, delivering a projected total return of 4.52% (Tables 3 & 4). Table 3Canada: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 4Canada: Expected Changes In Government Bond Yields Over The Next 12 Months Global Golden Rule: Australia Chart 6Aggressive Rate Hike Expectations On A Forward Basis For Australia Australian government bonds have delivered a negative excess return over cash of -9.6% over the past year (Chart 6). This is the biggest sell-off among all the countries covered in our Global Golden Rule framework. The magnitude of those realized losses far exceeded what would have been predicted by the Golden Rule a year ago, with the Reserve Bank of Australia (RBA) delivering only a modest hawkish surprise. An unexpectedly high Australian headline inflation print of 5.1% in Q1 of this year led the RBA to deliver a surprise +25bps rate hike in April. This created a mild hawkish policy rate surprise of -17bps over the past 12 months, as only +8bps of tightening had been discounted in the Australian OIS curve in May 2021. The Australian OIS curve is now discounting 292bps of rate hikes over the next year, taking the cash rate to just over 3% - a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. The RBA appears confident in the Australian economy, forecasting the unemployment rate to reach a 50-year low around 3.5% in 2023. However, we believe the RBA will be more measured in its pace of rate increases over the next year than markets expect, as global traded goods inflation cools and Australian wages are still not overheating. According to the Golden Rule projections, our base case of +150bps of tightening will produce a decline in Australian government bond index yield of -92bps, delivering a projected total return of 9.29% (Tables 5 & 6). Table 5Australia: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 6Australia: Expected Changes In Government Bond Yields Over The Next 12 Months Global Golden Rule: UK Chart 7The BoE Will Hike Less Than Markets Expect UK government bonds have gotten hit hard over the past year, delivering a negative excess return over cash of -7.9% - one of the worst performances seen over the past quarter century (Chart 7). The size of that loss was in line with the Global Golden Rule forecasts, given the magnitude of the rate shock seen in the UK. The Bank of England (BoE) hiked rates by 90bps over the past 12 months, which was a hawkish surprise of -79bps compared to what was discounted one year earlier. The UK OIS curve is now priced for another +139bps of rate hikes over the next year. This would take the BoE’s Bank Rate to 2.4%, a level that would push the UK unemployment rate up by two percentage points and lower UK inflation to below 2% within the next 2-3 years, according to the BoE’s own forecasting models. As we discussed in our report last week, where we upgraded our stance on UK Gilts to overweight, the neutral level of UK policy rates is between 1.5-2%, at best, with UK potential growth barely above 1%. Thus, markets are already pricing in a very restrictive monetary policy stance from the BoE that is unlikely to be fully delivered before UK growth and inflation decline sharply. Our base case calls for the BoE to deliver only another +75bps of hikes over the next year, which will produce a fall in the UK government bond index yield of -21bps and a total return of 4.12% (Tables 7 & 8). Table 7UK: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 8UK: Expected Changes In Gilt Yields Over The Next 12 Months Global Golden Rule: Germany Chart 8German Bunds Stand To Gain From An ECB Dovish Surprise German government bonds suffered major losses over the past year, underperforming cash by -8.5% over the past year. We saw no policy surprise from the European Central Bank (ECB) over that time relative to market expectations (Chart 8). The dramatic sell-off instead reflected surging expectations of future tightening as the euro area faces an energy-driven inflation spike. The trailing 12-month policy rate surprise for Germany (and the overall euro area) remains stuck near zero. However, markets now expect a very aggressive move by the ECB, discounting a full +156bps of tightening over the next 12 months. This would push the ECB’s main refinancing rate to levels last seen in the disastrous tightening cycle during the 2011 European debt crisis. As argued by our colleagues at BCA Research European Investment Strategy, the euro area is heading into a growth slowdown and energy inflation looks set to peak. Even if the hawks are able to sway the ECB Governing Council to begin hiking rates this summer, the slowing trajectory of growth and inflation make it highly unlikely that the ECB will deliver the full amount of tightening currently discounted. Our base case is that the ECB will deliver only +50bps of tightening over the next 12 months, enough to push the deposit rate out of negative territory to 0%. As shown in Tables 9 & 10, this is consistent with the Germany government bond index yield falling -55bps, delivering an index return of 5.07% over a 12-month horizon. Table 9Germany: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 10Germany: Expected Changes In Bund Yields Over The Next 12 Months Global Golden Rule: Japan Chart 9The Upside On A BoJ Dovish Surprise Is Limited Japanese government bonds (JGBs) have delivered an excess return versus cash of -1.8% over the past twelve months (Chart 9). The policy rate surprise was flat as the Bank of Japan (BoJ) kept the policy rate unchanged at -0.1%. Admittedly, the Golden Rule framework is poorly suited to project Japanese bond returns. The BoJ has been unable to lift policy rates for many years, while instituting yield curve control on 10-year JGBs since 2016 to anchor yields near zero. With no variability on policy rates or bond yields, a methodology that links bond returns to unexpected policy interest rate changes will have poor predictive power. However, rates traders are making some attempt to challenge the BoJ’s ultra-dovish posture. The Japan OIS curve now discounts +9bps of tightening, approximately enough to push the policy rate to zero, over the next 12 months. With the yen weakening rapidly and the cost of imported energy elevated, consumer price inflation in Tokyo (excluding fresh food) hit the BoJ’s 2% target in April. However, as evidenced in the minutes of the March BoJ meeting, policymakers see a sustainable inflation overshoot as unlikely. Our base case is the “Flat” scenarios shown in Tables 11 & 12, with the BoJ keeping policy rates unchanged for the next twelve months and delivering a slight dovish surprise. That generates a Golden Rule forecast of a -6bps fall in the Japanese government bond index yield, with a total return projection of 0.87%. Table 11Japan: Government Bond Index Total Return Forecasts Over The Next 12 Months Table 12Japan: Expected Changes In JGB Yields Over The Next 12 Months Investment Implications Of The Global Golden Rule Projections For all the countries discussed above, our base case calls for the respective central banks to deliver less tightening than markets are discounting over the next year. This suggests that government bonds should be expected to deliver positive returns versus cash, even as we expect multiple rate increases from all central banks except the BoJ. While this could argue for an above-benchmark duration stance at the overall global level, we prefer to translate the Global Golden Rule results via country allocations – as we have greater conviction on relative central bank moves in the current high inflation environment – while keeping overall global duration exposure at neutral. The return outcomes for our base case scenarios for the six countries in our Global Golden Rule framework are presented in Table 13. We show the expected returns both in local currency and hedged into US dollars, the latter allowing a comparison in common currency terms. In our base case scenarios, we expect Australian and German government bonds to deliver the strongest performance over the next year, followed by the UK, Canada, the US and Japan. Table 13Our Global Golden Rule Base Case Scenarios For The Next 12 Months Chart 10Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Our UK upgrade to overweight last week was a change to our strategic call on Gilts. Based on the results from our Global Golden Rule update, increased exposure to UK Gilts should be “funded” in a global bond portfolio by reducing exposure to Japan, with JGBs expected to deliver the weakest returns. Cutting JGB exposure also fits with the signal from our Global Duration Indicator, which is heralding a peak in global bond yield momentum in the latter half of 2022 (Chart 10). JGBs are typically a good “defensive” overweight country allocation in an environment of rising global bond yields. Persistently low Japanese inflation prevents the BoJ from credibly signaling rate hikes when other central banks like the Fed are lifting rates in response to stronger growth or overshooting inflation as is currently the case. The relative performance of Japan versus the Bloomberg Global Treasury benchmark index (in USD-hedged terms) is highly correlated to the year-over-year momentum of the overall level of global bond yields. With our Duration Indicator signaling a peak in yield momentum, we expect JGBs, which continue to exhibit a very low “beta” to changes in global bond yields, to underperform. Thus, this week we are downgrading our strategic allocation to Japan from overweight (4 out of 5) to underweight (2 out of 5). We view this as an offsetting recommendation to our UK upgrade from last week, while leaving our other country allocations unchanged. The result is that our country recommendations now line up with the expected returns from our Global Golden Rule, as can be seen in Table 13. That includes leaving the recommended US Treasury exposure at underweight, as we expect the Fed to deliver the smallest dovish surprise out of the central banks discussed in this report. We are adding both of the view changes made over the past two weeks, upgrading the UK and downgrading Japan, to our model bond portfolio as seen on pages 20-21. Bottom Line: Our Global Golden Rule suggests that developed market government bonds are expected to deliver positive returns over the next year as softening inflation momentum leads central banks to not fully deliver discounted rate hikes. Return expectations look most attractive in Australia, Germany and the UK, especially compared to the US and Japan. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Deborah Acri Research Associate deborah.acri@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcarearch.com. 2 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25, 2018, available at gfis.bcaresearch.com. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades