Currencies
Highlights Entering 2H21, oil and metals' price volatility will rise as inventories are drawn down to cover physical supply deficits brought about by the re-opening of major economies ex-China. As demand increases and oil and metals supply become more inelastic, forward curves will backwardate further. This will weaken commodity-price correlations with the USD and boost commodity-index returns. Going into next week's OPEC 2.0 meeting, the Kingdom of Saudi Arabia (KSA) and Russia likely will hold off on further production increases, until greater clarity around US-Iran negotiations and the return of Iran as a bona fide exporter is available. Chinese authorities will release 100k MT of copper, aluminum and zinc into tight domestic markets in July. A two-day rally followed the news. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, following the ~ 230% move in crude oil and the ~ 100% rise copper prices. Higher volatility will present buying opportunities for these ETFs (Chart of the Week). We remain long commodity index exposure – S&P GSCI and COMT ETF – expecting steeper backwardations. We will go long the PICK ETF at tonight's close again, after being stopped out last week with a 23.9% return. Feature Heading into 2H21, industrial commodity markets will continue to tighten. In the case of oil, this is caused by OPEC 2.0's production-management strategy – i.e., keeping supply below demand – and capital discipline among producers in the price-taking cohort.1 Base metals, on the other hand, are tightening because demand is recovering much faster than supply.2 Re-opening of major economies will boost refined-product demand in oil markets – e.g., gasoline and jet fuel – which will leave refiners little choice but to continue drawing on inventories to cover supply shortfalls in the near term (Chart 2). Chart of the WeekResources ETFs Follow Prices Higher Chart 2Refiners Will Continue Drawing Crude Investments Base metals – particularly copper and aluminum – will remain well bid in the face of constrained supply and higher consumption ex-China. Despite China's widely anticipated decision to release strategic stockpiles of copper, aluminum and zinc next month into a tight domestic market – which we flagged last month – continued inventory draws will be required to cover physical deficits in these markets, particularly in copper (Chart 3).3 Chart 3Copper Inventories Will Draw As Demand Ex-China Rises Chart 4Steeper Backwardation, Higher Volatility Higher Vol On The Way As demand for industrial commodities increases and inventories continue to draw, forward curves will become more backwardated – i.e., material delivered promptly (next day or next week) will command a higher price than commodities delivered next month or next year: Consumers value current supply above deferred supply, and producers and merchants have to charge more to cover inventory replacement costs, which increase when prompt demand outstrips supply. The steepening of forward curves for industrial commodities will lead to higher price volatility in oil and metals markets, particularly copper: Demand will confront increasingly inelastic supply. In this evolution, prices will be forced to allocate inelastic supply as demand increases. Sometimes-sharp changes in price are required to equilibrate available supply with demand when this happens. This can be seen clearly in oil markets, but it holds true for all storable commodities (Chart 4).4 Investment Implications Industrial commodity markets are entering a more volatile phase, which will be characterized by sharp price movements up and down over the short term, as demand continues to outpace supply. Our analysis suggests this is the beginning of a more volatile phase in industrial commodity markets. The balance of risk in industrial commodity prices will remain to the upside as volatility increases. In the short term, fundamental imbalances can be addressed over a relatively short months-long horizon – i.e., OPEC 2.0 can release spare capacity over a 3-4 month interval to accommodate rising demand – so that price increases do not destroy demand as oil-exporters are rebuilding their fiscal balance sheets. Base metals markets will have a tougher time in the short run finding the supply to meet surging demand, but it can be done over the next year or so without prices getting to the point where demand-destruction sets in. Over the medium to long term, investor-owned oil and gas producers literally are being directed by policymakers, shareholders and courts toward an extended wind-down of production and investment in future production. Markets have been pricing through just such a situation in the post-COVID-19 world, with OPEC 2.0 managing supply against falling demand and still managing to reduce inventories significantly. If the world follows the IEA's pathway to a decarbonized future – in which no investment in new oil or gas production is required after 2025 – this will become the status quo for these markets going forward.5 Metals producers, on the other hand, are being encouraged to increase marketable supply at a rapid pace to accommodate demand driven by the build-out of renewable energy – chiefly wind and solar – and the grids that will be required to move this energy. Producers, however, remain reluctant to do so, fearing their capex investment to build out supply will produce physical surpluses that depress returns, similar to the last China-led commodity super-cycle. Supplying the necessary base metals to make this happen will be difficult at best, according to Ivan Glasenberg, CEO at Glencore. At this week's Qatar Economic Forum, he said copper supply will have to double between now and 2050 to meet expected demand for this critical metal. “Today, the world consumes 30 million tonnes of copper per year and by the year 2050, following this trajectory, we’ve got to produce 60 million tonnes of copper per year,” he said. “If you look at the historical past 10 years, we’ve only added 500,000 tonnes per year … Do we have the projects? I don’t think so. I think it will be extremely difficult.”6 The volatility we are expecting in oil, gas and base metals prices, will present buy-the-dip opportunities in related equities vehicles. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, matching the ~ 230% move in crude oil and the ~ 100% rise in copper prices. We remain long commodity index exposure – S&P GSCI, which is up 5.9% and the COMT ETF, which is up 7.6% – expecting steeper backwardations. The trailing stop on our MSCI Global Metals & Mining Producers ETF (PICK) position recommended 10 December 2020 was elected, which stopped us out with a gain of 23.9%. We are getting long the PICK again at tonight's close. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Commercial crude oil stocks in the US (ex-SPR barrels) fell 7.6mm barrels w/w in the week ended 18 June 2021, according to the US EIA. Including products, US crude and product inventories were down 5.8mm barrels. US domestic crude oil production was down 100k b/d, ending the week at 11.1mm b/d. Overall product supplied, the EIA's proxy for refined-product demand, was up 180k b/d at 20.75mm b/d, which is 129k b/d below 2019 demand for the same period. At 9.44mm b/d, gasoline demand was just below comparable 2019 consumption of 9.47mm b/d, while jet-fuel demand remains severely depressed vs. comparable 2019 consumption at 1.58mm b/d (vs. 1.92mm b/d). Distillate demand (e.g., diesel fuel) for the week ended 18 June 2021 was 3.95mm b/d vs. 3.97mm b/d for the comparable 2019 period. Base Metals: Bullish Benchmark spot iron ore (62% Fe) prices are holding above $210/MT in trading this week, as demand for the steel input remains strong in China (Chart 5). The Chinese Communist Party (CCP) increased its level of intervention in the iron ore market this week, launching investigations into “malicious speculation,” vowing to “severely punish” anyone found to be engaged in such behavior, according to ft.com.7 Benchmark iron ore prices hit $230/MT in May. We continue to expect exports from Brazil to pick up in 2H21, which will push prices lower in 2H21. Precious Metals: Bullish In the aftermath of last Wednesday’s FOMC meeting gold prices lost nearly $86/oz (Chart 6). Our colleagues at BCA Research's USBS believe markets are paying too much attention to the Fed’s dot plots, and not to the central bank’s verbal guidance.8 Originally, the Fed stated that it will only start raising interest rates once a checklist of three conditions have been met. This checklist includes guidance on actual and expected inflation rates and the labor market. Gold prices did not react to Chair Powell's testimony before the House Select Subcommittee on the Coronavirus Crisis. Ags/Softs: Neutral US spring wheat prices are rallying on the back of dry weather in the northern Plains, while forecasts for benign crop weather in the Midwest pressured soybeans lower this week, according to successfulfarming.com. Chart 5 Chart 6 Footnotes 1 Please see our most recent oil price forecasts published last week in Balance Of Risks Tilts To Higher Oil Prices. It is available at ces.bcaresearch.com. 2 Please see A Perfect Energy Storm On The Way published on June 3, 2021 for further discussion. 3 Please see Less Metal, More Jawboning published on May 27, 2021, which flagged China's likely decision to release strategic stockpiles of base metals. 4 Chart 4 shows implied volatility as a function of the slope of the forward curve, i.e., the difference between the 1st- and 13th-nearby futures divided by the 1st-nearby future vs implied volatilities for Brent and WTI options. This modeling extends Kogan et al (2009), mapping realized volatilities calculated using historical settlements of crude oil futures against the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009), "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64:3, pp. 1345-1375. 5 Please see fn 2's discussion of the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector beginning on p. 5 under The Case For A Carbon Tax. 6 Please see Copper supply needs to double by 2050, Glencore CEO says published on June 23, 2021 by reuters.com. Of course, being a copper producer with large-scale base-metals projects due to come on line in the next year or so, Mr. Glasenberg could be talking his book, but as Chart 3 shows, copper has been and likely will be in physical deficits for years. 7 Please see China cracks down on iron ore market, published by ft.com on June 21, 2021. 8 Please see How To Re-Shape The Yield Curve Without Really Trying, published on June 22, 2021. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights The sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity demand and prices through the remainder of 2021. Commodity demand shocks dominate commodity supply shocks. Commodity supply shocks play only a transient role in setting prices. Go underweight basic resources equities versus the market. Commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar. Fractal trade: Short corn versus wheat. Feature Chart of the WeekDeclining Chinese Lending Is A Headwind For Metal Prices The recent collapse in China’s credit impulse has caught a lot of people’s attention, ours included. The collapse in the credit impulse quantifies the change in lending. Importantly, this means that even if the lending numbers themselves are large, the impulse will collapse if those lending numbers are declining – which is precisely what has happened in China. In the past year, China’s broad money supply has expanded by $17 trillion yuan, signifying a large amount of lending in the $100 trillion yuan economy. All well and good, except that the $17 trillion yuan has declined from an even larger $21 trillion yuan a year ago. To the extent that loans fund the demand for something, the $4 trillion yuan decline in those loans means that the demand for the something also declines. In the case of China, the something is the demand for industrial commodities, especially industrial metals (Chart of the Week). Using total social financing rather than the broad money supply reveals a similar downtrend in lending, and therefore a similarly collapsed impulse (Chart I-2 and Chart I-3) But as we explain in the next section, our preference is to focus on China’s broad money supply. Chart I-2Chinese Lending Is ##br##Declining... Chart I-3...So The 12-Month Credit Impulse Has Collapsed Declining Chinese Lending Is A Headwind For Metal Demand When interpreting the lending numbers in any economy, there are four important things to keep in mind. First, we should focus on bank lending. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody’s spending power goes down. In contrast, when somebody borrows by issuing a bond, it just reallocates spending power from one person to another. The bond issuer sees his bank account and spending power go up, but the bond buyer sees his bank account and spending power go symmetrically down. Demand will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, and as already mentioned, the impact on economic demand comes from the change in lending – which is to say the credit impulse. This is just to compare apples with apples. Remember that GDP, demand, and lending are all flow statistics. Meaning that the change in demand depends on the change in lending (and not from absolute lending itself).1 Third, the most important part of lending is bank lending to the non-financial sector.2 This is because not all loans generate economic activity. Bank-to-bank lending and reserves held at the central bank stay trapped in the financial system. The money supply – which is on the liabilities side of the banks’ balance sheet – might not pick up this distinction. It could be expanding rapidly due to a surge in bank-to-bank lending and/or in reserves, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending – which is on the assets side of the banks’ balance sheet – and only count lending that is likely to generate economic activity. However, this logic only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. Total social financing includes most, but not all, shadow lending. Yet all shadow lending must eventually show up in the money supply. For this reason, in analysing Chinese lending, we prefer to focus on the broad money supply. Having said that, the messages coming from both the broad money supply and total social financing concur. Chinese lending is slowing. Chinese lending is slowing. Fourth, we should choose the periodicity of the analysis to maximize its predictive power. This will depend on the specific lead times between the lending and the demand that it is funding, which will be discovered empirically. We find that the 1-year change in China’s broad money supply provides an excellent 1-year lead on industrial metal prices, because the lending leads commodity demand. The obvious rejoinder is, what about tight supply? The answer, from a recent academic paper – Drivers of commodity price booms and busts in the long run – is that for (non-oil) commodities, demand dominates supply. Specifically, “aggregate commodity and commodity-specific demand shocks appear to strongly dominate commodity supply shocks in driving variation in real commodity prices… commodity supply shocks play a rather secondary and transient role.”3 On this basis, we conclude that the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021 (Chart I-4 and Chart I-5). Chart I-4Declining Chinese Lending Is A Headwind For Industrial Metals... Chart I-5...And Iron Ore ##br##Prices Chinese Lending Is An Investment ‘Super-Driver’ We are strong believers in investment reductionism. Our reductionist philosophy stems from two guiding principles: Occam’s Razor – which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle – which says that 80% of effects come from just 20% of causes.4 Investment banks hate investment reductionism. Given that they want to sell you as much product as possible, they make investment seem much more complicated than it is. Yet most of the moves in most financial markets result from a very small number of ‘super-drivers.’ Our objective is to un-complicate investment – to identify the super-drivers, and to call them right. Clearly, one super-driver right now is the evolution of the pandemic, and specifically the evolution of new variants of the virus, as we discussed in Viral Variants Strike Down The Reflation Trade. A second super-driver is the direction of the T-bond yield, because this drives the direction of many other market trends such as growth versus value, defensives versus cyclicals, and US versus Europe. As we discussed in Don’t Panic About US Inflation, the T-bond yield is likely to drift lower in the coming months. Today’s report identifies a third super-driver – the evolution of Chinese lending. To repeat, the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021. The sharp drop in Chinese lending over the past year is highly likely to weigh on commodity prices through the remainder of 2021. This means that basic resources equities are likely to underperform both in absolute terms, and relative to the broader market (Chart I-6 and Chart I-7). On a 6-month horizon, go underweight basic resources versus the market. Chart I-6Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Chart I-7...And Relative To The Broad ##br##Market It also means that commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar (Chart I-8 and Chart I-9). Chart I-8The Canadian Dollar Just Tracks Inflation Expectations Chart I-9The New Zealand Dollar Just Tracks Inflation Expectations Commodities Are Fractally Fragile Reinforcing the super-driver of a Chinese lending slowdown, the 260-day fractal structure of the commodity complex is at the same extreme of fragility that heralded turning-points in 2009, 2010, 2018, and 2020 (Chart I-10). Chart I-10The Fractal Structure Of The Commodity Complex Is Extremely Fragile As a reminder, a fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. At this point, as longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. Eventually though, when the longer-term investors re-enter the price setting process, the price snaps back towards the valuation anchor. A fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. In early May, we highlighted this fragility in the commodity complex and, exactly as anticipated, most commodities then started to correct. We are trading the on-going correction in commodities through a short position in PKB as well as short CAD/USD, and both positions are now in healthy profit. Staying on the theme of commodities, the 60 percent outperformance of corn versus wheat over the past year is only starting to correct now (Chart I-11). Hence, a recommended trade is to short the corn future (number 2, yellow) versus the wheat future (number 2, soft red) setting the profit target and symmetrical stop-loss at 12 percent. Chart I-11The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct Finally, relating to a non-commodity position, we have extended by 33 days the holding period of short France versus Japan. Thus far, the position has traded sideways so we are giving it more time to move into profit. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The change in lending is the definition of the credit impulse. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Voxeu.org: Drivers of commodity price booms and busts in the long run, David Jacks and Martin Stuermer. 4 Often known as the 80-20 rule. In fact, it could be 90-10, 95-5, or even 100-5 as the numbers do not have to add up to 100. 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According to BCA Research’s Emerging Markets Strategy service, the Indian rupee is about 7% cheaper than its fair value versus the US dollar. The concept of purchasing power parity (PPP) theorizes that the currency of an economy with higher inflation will…
Highlights The Indian rupee is about 7% cheaper than its fair value versus the US dollar. Expanding capital expenditures will boost India’s productivity and raise returns on capital. That will attract higher capital inflows, propelling the rupee. India also has a better inflation outlook compared to the US because of the government’s prudent fiscal policy and muted wage pressures. Foreign bond investors should stay overweight India in an EM local currency bond portfolio. Equity investors should upgrade India from neutral to overweight in view of receding pandemic-related disruptions. Feature The outlook for the Indian rupee over the medium term (six months to three years) is positive. In this report we will identify the two primary drivers of the rupee/US dollar exchange rate over this time horizon. The first is the relative purchasing power in the two economies. The second is return on capital; more specifically, relative return on capital in the two countries. Both indicate that the rupee will likely benefit from a tailwind over the next few years. The robust currency outlook also supports our bullish view on Indian local currency bonds versus their EM peers and US Treasuries. In this report, we will explain how this context, and the Indian market’s own idiosyncrasies, warrants favoring Indian bonds in a global fixed-income portfolio. Finally, we are upgrading Indian stocks back to overweight in an EM equity portfolio. Relative Purchasing Power Chart 1The Indian Rupee Is Below Its Fair Value The concept of “purchasing power parity (PPP)” theorizes that the currency of an economy with higher inflation will adjust lower (i.e., depreciate) relative to the currency of an economy that has lower inflation. The upshot is that the relative inflation dynamics of the two countries could provide insight into their exchange rate outlook. The top panel of Chart 1 shows that the rupee is currently cheap when measured against what would be its “fair value”. The latter has been derived from a regression analysis between the manufacturers’ relative producer prices of the two countries and the exchange rate. Notably, a deviation from the fair value has also been a good predictor of where the nominal exchange rate will head in the years to come. Whenever the rupee appeared cheap relative to its fair value, it tended to appreciate over the next few years. The opposite has also been true. The current deviation from the fair value implies that the rupee could appreciate by 7% in the coming years (Chart 1, bottom panel). A deeper look into the inflation dynamics reveals that almost all significant directional moves in the rupee-dollar exchange rate over the past 25 years can be explained by movements in the relative inflation differential between the two economies. The rupee typically depreciates versus the dollar when Indian inflation is rising relative to that of the US; and appreciates when the relative inflation is falling. The only times they briefly diverged were during or in the immediate aftermath of a crisis, such as the global financial crisis or the COVID-19 pandemic. However, they were quick to return to their long-term correlations. Relative Inflation Outlook Going forward, the relative inflation outlook favors the rupee. This is because the fiscal and monetary policies in India will likely be tighter in India than in the US for the foreseeable future. Incidentally, India’s core inflation has fallen significantly relative to that of the US in the past decade (Chart 2). India’s inflation is driven mainly by two factors. The first is food prices; more specifically, the “minimum support price” that the Indian government pays to the farmers to procure food grains. Since the government is by far the single largest purchaser, the price it pays usually sets the floor in the market. The ebbs and flows of this procurement price have had a telling impact on the country’s inflation over the past few decades (Chart 3, top panel). Chart 2India's Inflation Has Fallen Significantly In The Past Decade Chart 3Notwithstanding The Temporary Pandemic-Era Surge In Fiscal Spending … In recent years, however, the authorities have been careful and did not hike the procurement prices over much. That has helped to keep headline CPI in check. Further, the government legislated new farm laws last year, which will usher in private capital in the agriculture sector. This will help improve farm productivity and keep food prices under control1 in the future. Chart 4...Fiscal Policy Has Been Very Prudent Since The GFC The other driver of Indian inflation is fiscal expenditure. The rise and fall in government spending leads core inflation by about a year (Chart 3, bottom panel). Notably, even though fiscal spending has swelled over the past year to provide relief to a pandemic-stricken economy, this one-off surge is offset by collapse in output and demand. Besides, the odds are high that the government will revert to a tighter stance as soon as the pandemic is brought under control. Indeed, such a fiscal splurge represents a departure rather than a fixture in India’s fiscal policy. Ever since the global financial crisis, successive Indian governments adopted a rather prudent fiscal stance. Chart 4 shows that fiscal spending steadily declined from 17% of GDP in 2009 to 12% by 2019. The conservative stance was implemented by both the previous UPA government and the current NDA government which came to power in 2014. Such a stance not only helped to substantially reduce the country’s fiscal and primary deficits but was also instrumental to the steady decline in inflationary pressures. The wage pressures in the economy are also rather muted. In rural areas, both farm and non-farm wages have been growing at a slow pace and have often remained below consumer inflation for the past six years (Chart 5, top panel). A similar picture is seen in the central banks’ (RBI) industrial outlook surveys. The assessment for salary and remuneration shows a subdued outlook; in fact, the indicator is below zero (Chart 5, bottom panel). This implies that wage pressures in the industrial sector have also been very low since 2017. Going forward, as tens of millions of young people continue to join the work force every year, the broader picture is unlikely to change. Overall, subdued wage pressures will also keep a tab on general inflation in the economy. Relative Return On Capital The other important driver of the rupee versus the dollar over the medium term is the direction of Indian companies’ return on capital relative to those of the US. When the return on capital rises, especially relative to that of the US, foreign capital flows into India in search of higher profits. Those capital inflows help boost the rupee. Chart 6 shows that over the past 25 years the rupee strengthened versus the dollar during those periods when return on assets of Indian non-financial corporates rose. The rupee depreciated when this ratio dropped. Chart 5Inflation Outlook Remains Sanguine As Wage Pressures Are Muted Chart 6Rupee Strengthens When Relative Return On Capital In India Rises... The same holds true when Indian firms’ return on assets are compared relative to those of the US. All major moves in rupee strength and weakness largely coincided with the relative rise and fall in return on assets (Chart 6, bottom panel). Chart 7...As Foreign Capital Inflows Into India Boosts The Rupee Thus, relative profitability clearly has a major influence on the exchange rate. And as alluded to earlier, the link is via capital inflows. The ebbs and flows of capital into India have a very explicit impact on the rupee (Chart 7). Going forward, a pertinent question is in which way will India’s return on capital be headed. Our bias is that, beyond the pandemic-related disruptions, it is heading higher over the medium term. We have the following observations: A sustainable rise in return on capital is highly contingent on productivity gains. And the latter depends on capital investment in new plants, machinery, technology, as well as on infrastructure. Thus, a meaningful and sustained rise in capital expenditures could be a harbinger of higher returns in the future. Firms, on their part, would engage in new capital expenditures once they are sanguine of future demand as well as profits. Notably, both gross and net profits of India’s non-financial sector have rebounded rather strongly. Capital expenditure has recovered in tandem (Chart 8). The latter indicates that companies do not consider profit recovery a fluke and are confident demand will remain upbeat. Corroborating the above, imports of capital goods have skyrocketed. This is also a precursor to higher capex down the road (Chart 9). Chart 8Rebounding Profits Have Encouraged Firms To Resume Capex... Chart 9...As Evidenced In Accelerating Capital Goods Imports Chart 10Capital Goods Imports Have Been Rising For The Past Several Years Markedly, India’s import profile has been encouraging in recent years. The share of capital goods in total imports and non-oil imports have been rising (Chart 10). This indicates that firms have not been averse to capital expenditure. This also shows that unlike in some other EM countries, imported consumer goods did not overwhelm India’s capital goods imports. The last time India saw a surge in capital goods imports was in the 2000s, a period when the country’s capex and profits also surged. That period coincided with a multi-year bull run in the rupee and stocks. The early 2010s, on the other hand, saw a deceleration in capex and capital goods imports – and was followed by a period of sub-par return on capital. Now, the tides are turning again. Finally, the quality of capital inflows has also improved over the past decade. India has been receiving ever higher amounts of FDI compared to portfolio inflows (Chart 11). The former is a much more efficient form of capital and are also more likely to boost capital expenditures enhancing productivity in the economy. Incidentally, India’s real gross fixed capital formation has hovered between 30% and 35% of GDP since 2008 – easily the highest rate globally, save China (Chart 12). Hence, if a new capex cycle ensues, which seems likely, it will happen over and above the base built over the past decades. That should help drive labor productivity and profits up by a notch. Chart 11...Along With Steady Growth In FDI Chart 12A New Capex Cycle On Top Of The Previous Base Will Boost Productivity All in all, odds are that Indian productivity will improve going forward, which in turn will boost firms’ profitability metrics. That should help propel the rupee. Bond Bullish The combination of a stable currency, prudent fiscal policy, and a benign inflation outlook make Indian bonds highly desirable to foreign investors. Notably, thanks to some systemic factors, Indian bonds are not as sensitive to bouts of fiscal profligacy and/or inflation in India: Over the past 20 years or so, ten-year bond yields hovered in a rather narrow band of 6%- 9%. A crucial reason for that stability is very limited foreign holdings: only about 2% of Indian government bonds are held by foreign investors. This has reduced yield volatility substantially. In many EM countries, where foreign holdings are much higher, a negative growth shock usually leads to both rising bond yields and a depreciating currency – which perpetuate each other – as foreign investors head for the exit. In the case of India, a negative shock is tempered by falling bond yields, as domestic investors switch from riskier assets to government bonds. Not only are the foreign holdings in India too small to push up yields but the falling yields also encourage them to stay invested. That explains why bond yields in India fell during each of the crises: in 2008-09, 2014-15 and more recently in 2020. A second reason is the existence of captive domestic bond investors: commercial banks. As per the Reserve Bank of India mandate, all banks in India are obligated to hold a certain percentage (currently 18%) of their total deposits in government securities (called Statutory Liquidity Ratio, or SLR). These mandatory holdings have also helped reduce yield volatility. The impact of the above factors can often be seen at play. For one, a surge in India’s fiscal expenditure does not necessarily cause a spike in bond yields. This is because, devoid of any fear of dumping by foreign bond holders, India can and does ramp up government spending when growth is very weak. Those are the times when domestic investors shed riskier assets and move to the safety of government bonds. Hence, we see accelerating fiscal spending coinciding with low and falling bond yields, unlike in many other EM countries (Chart 13, top panel). For a similar reason, a surge in India’s fiscal deficit does not necessarily cause a spike in bond yields either. If anything, widening budget deficits usually coincide with falling bond yields; and shrinking deficits with rising bond yields (Chart 13, bottom panel). The explanation for this apparent anomaly is as follows: periods of stronger growth bring in more fiscal revenues and thus reduce the deficit. But strong growth and rising inflationary pressures also lead to higher interest rate expectations reflected in higher bond yields. The opposite happens when growth slows. Even though fiscal deficit goes up as revenues drop, decelerating inflationary pressures pave the way for lower bond yields. A pertinent question here is, given the idiosyncrasies of Indian bond markets, what then drives Indian bond yields? The simple answer is the business cycle. This is why rising bond yields coincide with stronger bank credit growth and falling yields with weaker credit growth (Chart 14). Chart 13A Surge In Fiscal Spending Or Deficits Doesn't Mean A Spike In Bond Yields Chart 14The Business Cycle Is The Ultimate Driver Of Indian Bond Yields What is also notable is that the impact of any spike in consumer and/or producer price inflation on bond yields is not very pronounced (Chart 14, bottom panel). A crucial reason for that is again the SLR. Because of it, regardless of commercial banks’ own inflation expectations, they cannot dump government bonds. That puts a cap on bond yields even when inflation is rising. Besides, a rise in inflation usually coincides with accelerating bank credit and bank deposits. The latter causes higher demand for government bonds from banks (to maintain SLR). That in turn helps keep the bond yield lower than it otherwise would be. Chart 15The Spike In Public Debt Is Temporary, And Bond Investors Are Not Worried Bottom Line: The absence of foreign investors, the presence of large captive domestic investors and a long-held orthodox fiscal stance have turned the Indian bond market into a different ball game than many other EM local currency bond markets. One takeaway from this idiosyncrasy is that the current steep, but temporary, fiscal deficit should not be a matter of concern for bond investors. For a similar reason, the recent rise in the public debt-to-GDP ratio should have little impact on bond yields (Chart 15). Finally, a moderate rise in inflation is also unlikely to cause Indian bond yields to soar. Investment Conclusions The medium-term outlook for the Indian rupee is positive. It is also quite competitive, especially when compared to the currencies of India’s major competitors vying for multinationals to establish their manufacturing capacity (Chart 16). This means the rupee has some room for nominal appreciation without hurting its competitiveness. Chart 16The Indian Rupee is Quite Competitive This emphasizes our view that investors should continue to overweight India in an EM fixed-income portfolio. While strong growth and higher US bond yields can drive up Indian government bond yields, the former will also push up the rupee – as detailed in a previous section. The currency returns will offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Notably, because of the latter, a similar rise in yields (say, 100 basis points) in India and US bonds will have a much less negative impact on total return terms for Indian bonds than in the case of US Treasurys. The long end of the Indian yield curve offers value: the 10-year bond yield is 200 basis points above the policy rate. The spread of India’s 5-year bond over that of the US is an impressive 550 basis points (Chart 17, top panel). Given the sanguine rupee outlook, odds are that Indian government bonds will continue to outpace US treasuries in total return terms – even when Indian growth accelerates and inflation rises modestly (Chart 18). Chart 17Indian Bonds Offer Value Relative To US And EM Counterparts Chart 18Higher Carry And A Stronger Currency Will Lead To Total Return OutperformanceWhen compared to the same-duration JP Morgan GBI-EM bond index, India offers a spread of 100 basis points. India has steadily outperformed that index in US dollar total return terms over the past several years (Chart 17, bottom panel). That is unlikely to change in future, thanks to the high carry and a relatively more stable currency. As such, investors should stay on with our recommendation of overweighting India in an EM local currency bond portfolio (Chart 18). Chart 19Go Overweight Indian Stocks In An EM Equity Portfolio Several factors that make the outlook for the rupee positive also argue for a positive outlook for Indian stocks. Like most other EM currencies, the rupee is pro-cyclical, and it tends to move with Indian share prices. Notably, Indian stocks have broken out of their previous highs (Chart 19). On a separate note, as the number of daily COVID-19 cases in the country have subsided, so have the chances of debilitating lockdowns. As such, economic activity is slated to gather steam. We had tactically downgraded India from overweight to neutral in an EM equity portfolio on April 22 in view of skyrocketing COVID-19 cases and deaths back then. Even though the pandemic situation had deteriorated considerably after our downgrade, share prices have staged a nice rebound to our surprise. It’s time to upgrade this bourse back to overweight (Chart 19, bottom panel). Investors should also stick with our sectoral recommendation of long Indian Banks and short EM banks. As we elaborated in our report on Indian banks, a recovery in the business and capex cycles would be very positive for Indian private sector banks (that make up 90% of the MSCI India Banks index) – given that they have aggressively cleansed their balance sheets of NPLs and have thereby already taken the hit in their earnings. Fixed-income investors should close the trade of receiving 10-year swap rates in India. We had recommended it along with other EM local rates back in April 2020 as a play on lower interest rates in EM. India’s 10-year swap rates have risen by 166 basis points since then. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 For more details see our report India’s Reform Drive: How Momentous (Part 1) dated 19 November 2020.
Highlights Tactically downgrade cyclical equities from overweight in Europe. The shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries create headwinds for the cyclicals-to-defensives ratio this summer. Weaker global inflation expectations, commodity prices, and a dollar rebound will accompany this period of turbulence. The relative technical and valuation backdrop will also contribute to this period. Short consumer discretionary / long telecommunication is a high-octane version of the trade. Short technology / long healthcare is its lower-risk / lower-reward cousin. This temporary portfolio shift is a risk management move to capitalize on our positive 18- to 24- month view on cyclicals. Feature Last week, we recommended investors adopt a more defensive tactical posture. They should raise cash and shift into defensive quality names in order to weather a summer replete with potential downside risk. This will place investors in a good position to shift back into a more aggressive stance this fall, when cyclical sectors should resume their outperformance. This week, we explore this idea in more detail. The combination of a Chinese credit slowdown, a potential transition in the driver of growth away from goods into services, and a shift in tone from global central banks will feed the expected market volatility this summer. European defensive stocks are set to outperform during this period. Buying telecommunication equities / selling consumer discretionary stocks is a high octane bet on this trend, while going long healthcare / short technology shares is its low-risk incarnation. Summer Storms This summer, three forces will feed some downside risk in the market and, more specifically, an underperformance of cyclical sectors relative to defensive ones: a transition in global growth, preliminary signs that global central banks will begin to take away the punch bowl, and disappointments caused by COVID variants. Growth Transition The global economy is set to cool down as we transition away from the first stage of the post-pandemic recovery. As we showed last week, China’s deteriorating credit impulse is consistent with global industrial activity receding from its extremely robust pace of expansion (Chart 1). The continued decline in China’s banking system excess reserve ratio suggests that total social financing flows will slow further. Consequently, China’s intake of raw materials and industrial goods will decelerate, which will impact global industrial activity negatively. Already, the New Orders component of China’s Manufacturing PMI has rolled over. The disappointment of Chinese retail sales last week further indicates that China will act as a drag on global growth in the coming quarters. We have also highlighted that the combined effect of higher yields and oil prices has become strong enough to alter negatively the path of global industrial activity going forward. Our Global Growth Tax indicator, which includes both variables, shows that the US ISM Manufacturing survey and the global manufacturing PMI have reached their apex and will moderate this summer (Chart 2). Chart 1The China Drag Chart 2Rising Costs Bite The problem for global growth is one of changing leadership. Global economic activity is not about to collapse, but the extraordinary surge in goods consumption that started in 2020 will make room for a catch-up in the service sector. As an example, US retail sales stand 15% above their pre-pandemic trends; however, services spending still lies 7% below its pre-pandemic tendency (Chart 3). Thus, as summer progresses, the recent deceleration in consumer spending on goods will continue and services will progressively pick up the slack. The change in growth leadership will cause some temporary trepidation in global economic activity, because it is happening when the effect of both the Chinese credit slowdown and the previous increase in yields and oil will be most potent. As a result, we expect the G-10 Economic Surprises Index to follow that of China and experience an air pocket this summer (Chart 4). Chart 3From Goods To Services Chart 4Where China Goes, So Will The G-10 The Chaperone Is On The Way More than 65 years ago, former Fed Chair William McChesney Martin noted that the job of central bankers was to be “the chaperone who has ordered the punch bowl removed just as the party was really warming up.” Chart 5The Chaperone Is Waking Up Today, the party is a rager, and central bankers are indicating that they will remove the punch bowl soon. Real estate speculation is worrying the Bank of Canada, and its balance sheet has already shrunk by C$99 billion, to C$476 billion. The Norges Bank has indicted that it will lift interest rates twice this year. The Reserve Bank of New Zealand is set to lift the Official Cash Rate soon. The Bank of England has begun to adjust its asset purchases and could begin a full-fledge tapering this year. The 800-pound gorilla is the Fed, which telegraphed more clearly last week its intention to raise rates twice in 2023, and therefore moved closer to the pricing of the OIS curve (Chart 5). Implied in this forecast, the Fed will start tapering its asset purchase in early 2022 at the latest. This change in tone by global central banks is not a major problem for the business cycle – global rates are still far below any reasonable estimates of the neutral rate of interest, but periods of transition in monetary policy are often associated with transitory market turbulences. This time will not be an exception, especially because it is happening when global growth is downshifting. Delta, Gamma, Epsilon, etc? Chart 6Depressed Macro Volatility With the rapid progress of vaccination, the worst of the COVID tragedy is behind us. Nonetheless, the pandemic is not yet fully in the rear-view mirror, not even in the Western nations that lead the global inoculation campaign. SARS-CoV-2 continues to evolve and will therefore produce new variants over time, some of which will be problematic. The UK illustrates this phenomenon. The government has postponed the so-called Freedom Day, when life returns to normal, by five weeks despite the country’s high vaccination rate. The Delta variant is significantly increasing among the unvaccinated and not fully inoculated Britons. Many countries will also face this problem. These delays will be minor and will not threaten national recoveries. However, they will feed market tensions in a context where global macro volatility is low (Chart 6), global growth is already peaking, and monetary accommodation is receding. Global Market Implications… The confluence of the change in global economic growth leadership, the upcoming liquidity removal, and the potential for short-lived delays to the global economic re-opening point toward a decline in global inflation expectations, a rebound in the US dollar, weaker commodity prices, and an underperformance of global cyclical relative to defensive equities. Over the coming months, inflation breakeven rates are likely to soften, while real yields will rise modestly. In May, US inflation breakeven rates peaked near 2.6%, their highest level in ten years. A weaker global growth impulse in combination with a Fed that is more willing to remove some monetary accommodation will cool inflationary fears among investors and cause inflation expectations to decline further. However, the specter of tighter policy will also support TIPS yields. Bond yields are likely to correct somewhat more over the summer. Bond prices have not yet fully purged their oversold conditions (Chart 7); thus, a decrease in inflation expectations will temporarily support Treasury prices, even if real yields do not fall. Recent market action is moving in this direction. Last week, by Thursday evening, 10-year Treasury yields had already lost their 9 bps rise that followed Wednesday’s FOMC meeting. 30-year Treasury yields have plunged to a four-month low. Bund yields are unable to hang on to their gains either. The dollar has more upside this summer. Higher real US yields offer a potent backing for a DXY that still refuses to drop below 89. Moreover, the greenback is a highly counter-cyclical currency and is particularly sensitive to the gyrations in the global industrial cycle. Thus, the deceleration in the global manufacturing cycle will create a temporary tailwind for the greenback. Over the past three years, the gap between US TIPS yields and the Chinese Economic Surprise index explained the fluctuation of the DXY; it currently points toward a continued rebound in the USD (Chart 8). Even if this move is ephemeral, it will have implications for investors this summer. Chart 7Technical Backdrop For Bonds Chart 8Near-Term Upside For The DXY Commodities will also suffer. Natural resource prices have rallied in a parabolic fashion and our Composite Technical Indicator is massively overbought (Chart 9). Meanwhile, Chinese authorities are verbally jawboning industrial metal prices and have begun to release copper, zinc, aluminum, and nickel from their stockpiles. In this context, the Chinese credit slowdown and the imminent removal of monetary accommodation in various corners of the globe will catalyze a correction in commodities, even if a new supercycle has begun. The recent travails of lumber prices, which have collapsed 47% since May 7 (while they still remain in technical bull market!), may constitute a canary in the coalmine for the wider commodity complex. Global cyclical equities have greater downside against their defensive counterparts. US markets are global trendsetters; while the S&P cyclicals have lost some altitude compared to defensives, they have yet to purge their oversold state and remain very expensive (Chart 10). This backdrop makes them vulnerable to slowing Chinese import growth, a stronger dollar, and weaker commodity prices. Chart 9Will The GSCI Follow Lumber? Chart 10Vulnerable Global Cyclicals … And European Investment Implications Chart 11European Cyclicals Are Also At Risk The European cyclicals-to-defensives ratio is vulnerable, like it is in the US. Hence, a more defensive portfolio bias makes sense for the summer, which should allow investors to regain maximum cyclical exposure later this year. Short consumer discretionary / long telecommunications and short technology / long healthcare are pair trades with particularly attractive risk profiles. The cyclicals-to-defensives ratio is technically unattractive. The relative share prices stand toward the top of their 16-year trading range (Chart 11). Moreover, their 52-week momentum measure is rolling over at a highly elevated level, while the 13-week rate of change is deteriorating. Meanwhile, the Combined Mechanical Valuation Indicator1 (CMVI) of the cyclicals towers far above that of the defensives and is consistent with a corrective episode (Chart 11, bottom panel). The drivers of the performance of Eurozone cyclical relative to defensive sectors confirm that cyclicals could suffer a turbulent summer. For instance: The potential for further declines in global yields does not bode well for the European cyclicals-to-defensives ratio (Chart 12). Weaknesses in market-based inflation expectations would prove particularly threatening (Chart 12, bottom panel). The deceleration in China’s total social financing flows anticipates an underperformance of European cyclicals (Chart 13). As China’s credit decelerates, so will the earnings revisions of cyclical equities. Moreover, a weaker Chinese TSF is consistent with falling Treasury yields. Chart 12Lower Inflation Expectations Equals Underperforming Cyclicals Chart 13Cyclicals Listen To China The potential for weaker commodity prices is another problem for European cyclical equities (Chart 14). Commodities capture the ebb and flow of global growth sentiment, which is also a driver of the earnings revisions of cyclicals relative to defensives. Moreover, commodity prices greatly affect the earnings of cyclical equities. Unsurprisingly, the momentum of the European cyclicals-to-defensives ratio correlates closely with the BCA Commodity Composite Technical Indicator (Chart 14, bottom panel). Cyclicals perform poorly when the dollar appreciates. The Eurozone’s cyclicals-to-defensives ratio moves in lock-step with the euro and high-beta cyclical currencies (Chart 15). These relationships reflect the counter-cyclicality of the dollar, as well as the negative effect on global financial conditions of its rallies, and thus, on the earnings outlook for cyclicals. Chart 14Beware The Impact Of Weaker Commodities Chart 15A Strong Dollar Hurts European Cyclicals Chart 16Short Consumer Discretionary And Long Telecommunication Based on these observations, we are tactically downgrading cyclicals from our overweight stance for the summer, despite our conviction that cyclicals have upside on an 18- to 24-month basis. We look at this move as risk management. For investors looking to bet on a potential underperformance of cyclical equities in Europe, we recommend two positions: a high-octane pair trade and a lower-risk one. The high-octane version is to sell consumer discretionary stocks and buy telecommunications ones (Chart 16). This pair trade is exposed to lower yields, lower inflation expectations, and the shift in growth drivers from China and goods consumption to services expenditures. Additionally, the relative 52-week momentum measure is overextended, while the 13-week rate of change is already sagging. The CMVI of the consumer discretionary sector is extremely elevated, while that of telecommunication stocks is the most depressed of any Eurozone sector. Consequently, the gap between the two sectors’ CMVI stands at nearly three-sigma, which is concerning because the RoE of consumer discretionary shares lies 7% below that of the telecoms industry (Chart 16, third and fourth panel). Because higher RoEs should justify higher valuations, consumer discretionary and telecommunication stand out as the greatest outliers among European sectors (Chart 17). As an added benefit, this trade enjoys a positive dividend carry of more than 2.5%. Chart 17Spot The Outliers Chart 18Short Technology And Long Healthcare The low octane pair trade is to sell technology stocks and buy healthcare names instead. This position offers lower expected returns but also a lower risk, because both sectors are growth stocks and they will benefit from falling yields and inflation expectations. However, based on their respective CMVI, tech equities are much more expensive than healthcare ones (Chart 18), while they are also extremely overbought. Thus, healthcare should benefit more from falling yields and inflation expectations than tech. Moreover, technology is a more cyclical sector than healthcare; it will therefore be more sensitive to the evolution of global growth. Bottom Line: We remain positive on the outlook for cyclical equities on an 18- to 24-month horizon, but the changing global growth leadership, the imminent removal of global monetary accommodation, and the demanding valuation and technical backdrop of the European cyclicals-to-defensives ratio suggest that a period of turbulence will materialize this summer. Thus, we are tactically downgrading cyclicals. Investors should consider going long telecommunications / short consumer discretionary as a high-octane tactical bet on this portfolio stance. Buying healthcare / selling technology would constitute a lower risk / lower return play. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1 For a detailed explanation of the Combined Mechanical Valuation Indicator, see Special Report, “Valuation – A Mechanical Approach,” dated May 31, 2021. Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
The yen has been the worst-performing currency in the developed FX space this year. Unlike the euro area or the US, the Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases is at the highest level per capita in developed…
The Brazilian real was up 1.4% versus the dollar on Thursday – a day of broad dollar strength. The gain comes on the back of the Central Bank of Brazil’s decision to hike rates by 75 bps for the third consecutive time, bringing the benchmark Selic rate to…
Emerging Markets Strategy has been recommending that investors position for a dollar rebound and believes the dollar’s move will be playable: it will be meaningful and last a few months. US dollar strength will be driven by both repricing of the Fed’s…
Highlights The yen is the most underappreciated currency in developed markets today. Our bullish thesis on the yen rests on a simple pillar: Japan will successfully overcome the pandemic like its Western counterparts. This good news is not yet reflected in the price of the yen or Japanese assets. The Japanese economy is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for any equity market or currency. Remain short USD/JPY. The biggest risk to our view is a big rebound in US Treasury yields that catalyzes outflows from Japan and bids up the dollar. Feature The Japanese economy remains under siege from the pandemic. The number of new Covid-19 cases is at the highest level per capita in developed Asia (Chart I-1). As a result, the manufacturing PMI is the lowest in the region (and the developed world for that matter), even though global demand for goods is booming. As an industrial powerhouse very much dependent on external growth, this result has been both surprising, and a severe blow to the domestic recovery. A third wave of infections has also crippled the services sector, pinning its recovery well behind its global peers. The combination has led to an underperformance of both the Japanese currency and stock market (Chart I-2). Chart I-1Japan Is A Basket Case In Developed Asia Chart I-2The Japanese Recovery Has Lagged There are a variety of hypotheses for Japan’s anemic recovery. The initial government response to the pandemic was slow and botched, with a nationwide lockdown only implemented on April 16 last year, much later than other economies. The health response has also been disappointing – despite a high availability of hospital beds, only a small percentage were used to treat Covid-19 patients. As a matter of fact, only a fifth of Japan’s 8,000+ hospitals are public, which has slowed the pace of both treatments and more recently, vaccinations. This is dampening both business and consumer sentiment, crippling the recovery. In this report, we explore how fast and how soon Japan can emerge from crisis management mode. More importantly, with Japanese shares and the currency laggards in this recovery, has the stage been set for a coiled-spring rebound? Our bias is that most of the bad news may already be reflected in depressed asset prices, while an inevitable economic recovery is not. Mapping The Japanese Recovery The pace of vaccination is accelerating in Japan and should soon hit the critical 50%-60% threshold necessary to reach herd immunity (Chart I-3). Shipments of the vaccine have been increasing since May, with 100 million Pfizer doses, and 40 million Moderna shots expected by the end of June. According to government officials, Japan aims to secure enough doses to inoculate its entire population by the end of September. Chart I-3AAn Accelerating Pace Of Vaccinations In Japan Chart I-3BCurrency Returns Have Roughly Tracked Vaccination Progress A turnaround in the vaccination campaign would not only boost public opinion about the Covid-19 response but would also be a welcome fillip to much subdued consumer and business sentiment. Economic surprises in Japan have flipped from being the most disappointing in the developed world to the most robust. Expectation surveys are also pointing to rising optimism about future growth (Chart I-4). It should only be a matter of time for hard data to follow suit. The first catalyst for a recovery will come from consumption, particularly around the Olympics. While foreign spectators will not be allowed in Japan, athletes, organizers and sponsors should jumpstart the pickup in inbound tourism. At the peak in 2019, tourist arrivals were almost 25% of the entire Japanese population, compared to almost zero today (Chart I-5). Chart I-4Green Shoots In Japan Chart I-5Nowhere To Go But Up More importantly, a pickup in tourism will also coincide with improvement in labor market conditions. Real wages are accelerating at the fastest pace in a decade. This is boosting household spending, as the unemployment rate declines. Should a recovery trigger less need for precautionary savings, this will further boost consumption (Chart I-6). It is important to note that significant headwinds to Japanese consumption are now abating. The consumption tax hike in 2019 delivered a severe punch to aggregate demand. COVID-19 eventually dealt a near-fatal blow. The silver lining is that those two shocks have led to a massive build in pent-up demand, which should be unleashed in the coming quarters. Government outlays have also gone a long way towards boosting aggregate demand during the pandemic. A new budget to be compiled in October or November should help ease the fiscal drag in 2022 (Chart I-7). The fiscal multiplier tends to be much larger in a liquidity trap, so it will be important for the government to resist the urge to rein in spending amidst a surging debt profile. Chart I-6A Recovery In ##br##Consumption Chart I-7The Fiscal Thrust In 2022 Could Be Less Negative Our bias is that a vigorous rebound in Japanese consumption, as was witnessed in other developed economies, could jumpstart the economic recovery. The Risk Of A China Slowdown A boom in external demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows. In our view, this risk should be monitored, but is likely overstated. First, while 23% of Japanese sales go to China, other developed and emerging markets account for the lion’s share of exports. For example, exports to the US account for 18% of sales while EU exports account for 9%. One of the most cyclical components of Japanese exports is machine tool orders, which continue to inflect higher. If Chinese growth does indeed slow, it accounts for large but not overwhelming 30% of overall orders (Chart I-8). From a much broader perspective, rising infrastructure spending and an economic recovery around the world should continue to buffer foreign machinery orders and demand for Japanese goods, keeping industrial production humming (Chart I-9). Chart I-8A Boom In Foreign Demand Chart I-9A Renewed Industrial Cycle Japanese Growth, Inflation And The Yen The best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Like most other economies, Japan saw the worst private-sector contraction in decades. For an economy whose interest rates have lingered near zero since the 1990s, this is not good news. However, whenever the structural growth rate of the Japanese economy (proxied as private-sector GDP) has begun to recover from very low levels (and even before), the trade-weighted yen has staged powerful rallies (Chart I-10). Chart I-10The Yen And Japanese Growth Part of the reason is that any Japanese growth improvement is likely to be non-inflationary. Most developed economies are seeing both realized or expected inflation at or exceeding their central bank’s targets. This is not the case in Japan (Chart I-11). This means that real rates should remain quite elevated, a positive for the currency. The three key variables the authorities pay attention to for inflation, core CPI, the GDP deflator and the output gap, are low and falling (Chart I-12). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population. This means that generating inflation is a more arduous task than in other developed economies. Meanwhile, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Chart I-11Higher Real Rates In Japan Chart I-122% = Mission Impossible? Real rates are likely to stay positive in Japan for the foreseeable future. For one, there is not much the BoJ can do in terms of easing policy. The central bank already owns 50% of outstanding JGBs, and about 89% of ETFs. As such, the supply side puts a serious limitation on how much more stimulus the BoJ can provide (Chart I-13). Chart I-13Stealth Tapering By The BoJ? Meanwhile, the most potent policy for the Bank of Japan is to keep Japanese rates low as global yields are rising. This is because yield curve control will incrementally lower the appeal of higher Japanese real yields. We expect that in an environment where global inflationary pressures are normalizing (3-6 months), this is much less of a risk. The Yen In The Current Global Context Foreigners have a huge sway on the performance of Japanese assets, especially equities. Foreign holders account for near 30% of the Japanese equity float (Chart I-14). The size of day-to-day flows could be much bigger. As such, a call on the yen is also predicated on substantial inflows from foreign buying. The yen and the Japanese equity market have historically been negatively correlated. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but true underlying productivity gains (Chart I-15). On this note, the return on equity of Japanese shares has overtaken that of the euro area, even though they still trade at a price-to-book discount to their European counterparts. This could result in less yen hedging by foreign investors, which would restore a positive relationship between the relative share price performance and the currency. Chart I-14Large Foreign Participation In Japanese Stocks Chart I-15A Breakdown In ##br##Correlation? As a counter-cyclical currency, the yen usually weakens against other developed market currencies when global growth picks up. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and any improvement in Japanese growth will revive talks about normalization from the BoJ. Even if the BoJ eventually stands pat, the starting point is extremely short positioning by speculators, which could trigger a potent short squeeze (Chart I-16). Chart I-16Dollar Weakness = Yen Strength (Usually) Finally, the yen rises versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. As such as a low-beta currency, the yen could weaken on its crosses, but still rise versus the dollar. Stay short USD/JPY. FX Trading Model We regularly update our FX trading model as a mechanical check on what could otherwise be subjective currency biases. Fortunately, our model agrees with us for the month of June, with recommendations to short the US dollar, mostly against the yen (Chart I-17). For risk management purposes, we are also tightening stops on our short AUD/MXN, and long Scandinavian currency basket positions to protect profits. Chart I-17ATrading Model Is Bullish Yen Chart I-17BTrading Model Is Bearish NZD Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The recent data out of the US have been robust: The May employment report showed an increase of 559K jobs, versus expectations of a 650K increase. The unemployment rate declined from 6.1% to 5.8% in May. The Jolts job opening survey showed an increase from 8.3mn to 9.3mn. CPI came in at 5% year on year in May, outpacing expectations of a 4.7% rise. Month on month, CPI grew by 0.6% in May, above the 0.4% consensus. Core CPI came in at 3.8% year on year in May, beating the expected 3.4%. The US dollar DXY index was down 0.4% this week. The broad theme in FX markets has been a normalization in US yields, despite a strong CPI report and an otherwise robust jobs report. This suggests market participants are already positioned for an upside surprise in US data. We are agnostic towards the US dollar in the next 1-3 months but will use any bounce as a selling opportunity. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain upbeat: The euro Sentix confidence index bounced from 21 to 28.1 in June. Both employment and GDP growth in the first quarter were better than expectations. The ECB kept monetary policy on hold but upgraded its economic forecasts for both 2021 and 2022. The euro was up 0.4% this week. While the focus on the euro has been on the possibility of the ECB tapering asset purchases, the biggest driver of the currency has been relative growth. We expect eurozone GDP to continue inflecting higher, in line with the ECB’s revised forecasts. This is bullish the euro. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan was robust: Average cash earnings rose 1.6% year on year in April. Overtime pay rose by 6.4%. The GDP report was revised upward, with year on year growth at -3.9% for the first quarter, compared to a previous assessment of -4.8%. The Eco Watchers Survey for May came in at 38.1, with the outlook component actually rising. Machine tool orders are inflecting higher, rising 141% year on year in May. The yen was up by 0.8% against the USD this week. The yen is the most underappreciated currency in developed markets today. Our bullish thesis on the yen rests on a simple pillar: Japan will successfully overcome the pandemic like its Western counterparts. This good news is not yet reflected in the price of the yen or Japanese assets. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data out of UK have been solid: Halifax house prices are rising almost 10% year on year as of May. The BRC retail sales monitor also remains robust at 18.5% year on year in May. The pound was up by 0.4% this week against the USD. Cable has already priced dividends from a fast vaccine rollout, and the positive impact on the domestic UK economy. As such, more pronounced GBP gains will need to stem from an improvement in UK productivity. We are bullish on GBP over the long-term based on valuation but will stand aside in the near term. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There was scant data out of Australia this week: The AIG Services index rose from 61 to 61.2. While the NAB business confidence index edged lower from 23 to 20 in May, the survey component was more upbeat, rising from 32 to 37. The AUD was up by 1.3% this week against the USD. Price pressures remain weak in Australia and the vaccination progress continues to lag, even though it has been accelerating lately. This will keep the RBA dovish. This provides a small window to short the AUD, as other central banks turn more hawkish. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: ANZ busines confidence came in at -0.4% in Q1, versus 1.8% last quarter. Electronic card retail sales increased by 1.7% month on month in May after a 4.4% increase in April. The NZD was up by 0.7 % this week against the dollar. The biggest risk to the New Zealand economy is a self-reinforcing deflationary spiral from a currency that rallies too far, too fast. However, in a context of slowing Chinese growth, this is less likely. We are short the NZD against the CHF, as insurance should a riot point in markets develop. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been as expected: Canada lost 68K jobs in May, but this was mostly tied to the lockdowns. Losses were concentrated to part-time employment. The unemployment rate did rise from 8.1% to 8.2%. The May Ivey PMI rose from 60.6 to 64.7. The Canadian trade balance improved from -C$1.4bn to a surplus of C$0.6bn in April. The Bank of Canada kept policy on hold this week, both in terms of interest rates and asset purchases. The CAD was flat against USD this week. Most of the normalization by the BoC has already been priced in the OIS curve, which is denting any near-term policy impact on the CAD. In our view, near term catalysts for the exchange rate will stem from what happens to crude oil prices as well as the Canadian recovery, as the world economy reopens. On this front, we remain bullish. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate fell to 3% in May, from 3.2%. CPI came in at 0.6% in May, double the rate of the previous month. The Swiss franc was up by 1% this week against the USD. The franc currently sits in a “heads I win, tails I do not lose too much” juncture. It is cheap with a real effective exchange rate that is at one standard deviation below fair value. As such, should the pickup in global trade continue, this will buffet the franc. That said, the franc also benefits from bouts of volatility as a safe-haven currency. On this basis, we are long CHF/NZD as contrarian play. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The was scant data out of Norway this week: Core CPI came in at 2.7% in May, lower than the previous month. PPI growth registered a 29.4% increase in April, year on year. The NOK was up by 1.3% this week against the dollar, the best performing G10 currency. Our special report on the NOK last week pointed to many catalysts that should keep the currency an outperformer in the coming quarters. We remain short both USD/NOK and EUR/NOK and are tightening stops this week to protect profits. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: The current account surplus rose from SEK 69.8bn to SEK 78.3bn in Q1. Industrial production came in at 26.4% year on year in April. CPI came in at 1.8% year on year and 0.2% month on month in May, in line with expectations. CPIF registered at 2.1% year on year and 0.2% month on month increase in May, both below the consensus. The SEK was up by 1.2% this week against the USD. Sweden stands to be one of the economies that benefits most from a renewed industrial cycle. This is by virtue of its export orientation and huge industrial concentration compared other economies. Meanwhile, the SEK remains one of the cheapest currencies in our models. We are short both EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades