Europe

Special Report

Executive Summary Definitions Matter Year-to-date, cyclical stocks have underperformed their defensive counterparts. It is difficult to quantify this underperformance precisely considering the divergence in definitions of what makes a sector cyclical or defensive. We offer a novel way to classify sectors based on a combination of equity beta coefficients and correlations with global macro and financial variables. Importantly, we acknowledge the importance of granularity by looking at the GICS2 sectors. This new approach leads to a cyclicals/defensives equity performance that is superior and more in line with the global economic cycle. Bottom Line: A proper definition of what constitutes a cyclical and a defensive equity sector is essential – whether a recession is around the corner and investors adopt a more defensive portfolio tilt or markets are just responding to what might simply be a mid-cycle slowdown.   Investors around the globe are holding their breath over two questions: Has inflation peaked? And will the US and Europe enter a recession? A peak in inflation may be enough to avoid a hard landing, as it would allow the Federal Reserve and the ECB to moderate their policy tightening. However, if inflation is not peaking, central banks will be forced to engineer recessions. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks In turn, the answers to these questions will determine how cyclical equities perform relative to defensives. So far, the underperformance of cyclical sectors relative to defensives has mostly reflected a valuation squeeze. But if a recession takes place, relative profits will drive the next phase of this market cycle. For now, European defensive sectors are likely to retain the upper hand until EM/China economic activity recovers enough to provide a lift to cyclical sectors, and/or the US dollar rally reverses course on a sustained basis. Chart 1Definitions Matter Despite their recent rebound, Euro Area cyclical stocks have underperformed relative to their defensive counterparts over the past nine months. However, quantifying this underperformance depends on how one defines cyclicals and defensives (Chart 1). The aim of this Special Report is to address this issue. There is no perfect way to define a sector as a cyclical or a defensive. In this piece, we review the generally accepted definitions. We draw two conclusions from our assessment; (i) the GICS1 sectors are too broad to get an accurate representation of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD Composite Leading Indicator (LEI), is lacking. We propose a different approach, which looks at the GICS2 sectors and applies an average of the market beta and the correlations to a set of global macro as well as financial variables sensitive to the global economy. This novel approach leads to a cyclicals/defensives equity performance that is more properly aligned with the global economic cycle. Challenging the Accepted Approach Each of the definitions of the cyclicals/defensives split has its own merit. For example, our own preferred definition of cyclical equities excludes the tech sector, because it sports a negative correlation with interest rates.     Finance theory posits that companies (or sectors) may be categorized based on how they perform in different phases of the business cycle. Consequently, cyclical companies should perform better in the first stages of a new business cycle (especially coming out of a recession) and defensive companies should shine during downturns. Table 1Definitions Matter MSCI defines cyclical and defensive sectors by measuring the correlation between sectors’ relative annual performance to the annual change in the OECD Composite Leading Indicator (LEI) of the corresponding region.1 Table 1 presents the current MSCI classification. There are two issues with this approach. First, results differ substantially depending on the sample period (Table 2). GICS1 sectors match their definitions when using the full history available (from 1995 to present). However, on shorter samples, starting for example from 2005 or 2015, the correlations do not necessarily support the current MSCI classification; the communication services sector correlates negatively with the Euro Area OECD LEI from 2005 to present,2 while the energy sector displays a positive correlation since 2015. Table 2Cyclicality Changes Over Time Looking at the five-year moving correlation of the relative performance of European sectors to the annual change in OECD LEI, four things stand out (Chart 2). First, the energy sector displays a positive correlation, meaning that it behaves as a cyclical. Second, it is not clear that communication services should be labeled a cyclical sector. Third, although tech has on average displayed a five-year moving correlation with activity of around 0.5, it is increasingly behaving like a defensive sector. And fourth, over the past 20 years, all sectors have at one point or another moved from a positive (negative) correlation to a negative (positive) one. Chart 2Cyclicality Is Not Static The second issue with the MSCI approach is the use of the OECD LEIs. While the OECD LEIs are satisfactory at capturing the peaks and troughs in economic activity, we have some concerns over relying on this measure alone to label a sector as cyclical or defensive. Many of the country’s LEIs already include stock prices. Moreover, academic studies have found that the LEIs performed worse than some of their single component indicators, but displayed more accuracy – that is, fewer false signals. In particular, financial components used in some of the country’s LEIs, such as interest rates, spreads, and credit indicators, proved to be better classifiers of both growth and business cycles than the overall LEIs. Chart 3Global Growth Sensitivity Finally, many (if not most) of the components of the LEIs are domestic variables. As a result, they may not properly reflect how the global economic and trade cycles affect an economy such as that of the Euro Area. In fact, the correlation between the relative performance of Euro Area cyclicals versus defensives and the annual change in the US and Global LEIs is similar to the correlation between the cyclical/defensive split and the Euro Area LEI (Chart 3).3  Reclassifying Cyclicals And Defensives We may draw two conclusions from our earlier assessment; (i) the GICS1 sectors are too broad to secure an accurate definition of cyclicals/defensives, and (ii) the use of only one indicator of cyclicality, such as the OECD LEI, is insufficient. Granularity Holds The Key Many industries or sectors have experienced profound changes over the past decades. Industries evolve and new ones emerge that may disrupt the status quo. For instance, today’s tech sector shares few similarities with its past-self twenty years ago. Chart 4AMore Granularity Needed (I) Without getting to the company level, many GICS2 sectors already exhibit characteristics deviating substantially from those of the GICS1 sectors of which they are a part (Chart 4A & 4B). Most noticeably: Within industrials: commercial and professional services (9% weight) have a negative correlation with the LEI of -0.23 (Chart 4A, top panel). Within consumer discretionary: the correlation of the retailing sector with the LEI (15% weight) went from 0.75 in the early 2010s to -0.5 in 2018 and has since been trending toward 0 (Chart 4A, third panel). Within tech: software and services (46% weight) sport a negative moving correlation of -0.25, and highlight that this sector has effectively become akin to “digital utilities.” Meanwhile, technology hardware and equipment display a correlation close to 0 (Chart 4A, fourth panel). Chart 4BMore Granularity Needed (II) Within communication services: telecommunication services (78% weight) still behave like a defensive sector, and it appears that the cyclicality of the GICS1 sector is driven by media and entertainment stocks (Chart 4B, top panel). Within consumer staples: food beverage and tobacco (53% weight) now display a positive correlation of 0.1 with the LEI, whereas it used to have a -0.8 correlation until 2018 (Chart 4B, second panel). Within energy: GICS2 sectors have displayed positive correlations since 2015 (Chart 4B, third panel). For the remaining GICS1 sectors, namely materials, financials, utilities, and healthcare, except for large swings observed in the past, their respective GICS2 sub-sectors currently display correlation coefficients sharing the same sign as their broader aggregates. Thus, adding granularity by looking at the GICS2 sector level instead of the GICS1 classification when creating cyclical and defensive baskets offers a more accurate picture. Good Old Beta Is the market itself the best indicator of a stock’s cyclicality? The returns on the stocks of cyclical (defensive) sectors should reflect high (low) correlation with the market index’s returns. Table 3A presents the beta coefficients obtained from linearly regressing the monthly equity returns of European GICS1 sectors on the monthly equity returns of the All-Country World benchmark. We run into the same issue of getting different results based on the sample period. Historically, the energy sector has had a beta coefficient below 1, but, from 2005, its beta has risen to 1.12. Meanwhile, communication services has a beta coefficient below 1 across all three sample periods selected. Table 3AGICS1 Beta Coefficients We perform the same exercise at the European GICS2 sector level (Table 3B). The results reify the benefit of additional granularity when defining cyclicals and defensives. Table 3BGICS2 Beta Coefficients Combining Correlations With Macro And Financial Variables While stock prices are certainly anticipatory, at times they can also decouple from the business cycle. Equity markets and stock indices are becoming more concentrated, which means that measuring cyclicality through beta alone is no longer sufficient. We complement the use of the beta coefficients with a composite measure of cyclicality based on correlations with global macro and financial variables. We select the following global macro variables (Chart 5A):​​​​​​​ Global Manufacturing PMI Global Industrial Production G3 Capital New Orders Global Exports Chart 5AGlobal Macro Variables Selected Chart 5BFinancial Variables Selected And we opt for the following high-frequency financial variables (Chart 5B): Trade-weighted USD: The cyclicals-to-defensives ratio and the trade-weighted US dollar display a robust negative correlation. A strong dollar both tightens global financial conditions and indicates weaker economic growth. GS Commodity Price Index: Commodity prices reflect both global supply and demand dynamics. Strong economic activity usually lifts commodity prices, while a slowdown hurts commodity demand. US 10-year Treasury Yield: The relationship with the US 10-year Treasury yield is somewhat more complex. At the beginning of a new business cycle, higher yields reflect reflation and usually correlate with an outperformance of cyclical equities. However, if yields rise too much, they start hurting growth prospects and end up damaging cyclicals. If they fall, it usually reflects increasing growth fears, which is negative for cyclical shares. Junk Spreads: US high-yield corporate bond spreads and the cyclicals/defensives ratio have a strong negative correlation. Widening junk spreads coincide with the end of the business cycle when fears of rising default risk precede a recession. Although these financial variables are highly anticipatory, they are also prone to whipsaws. Consequently, they must be viewed in conjunction with macro variables. We also compute the five-year moving correlations between monthly equity returns of European sectors relative to the ACW benchmark and the two sets of macro and financial variables (Table 4A & 4B). The results are broadly consistent between the long-term correlations with macro and financial variables, as well as with the beta coefficients,4 which comforts us into using a simple average of the three. Table 4ACombining Coefficients For GICS1 Sectors Table 4BCombining Coefficients For GICS2 Sectors At the GICS1 sector level, our new approach indicates that the energy sector should be treated as a cyclical, not a defensive. In fact, it displays more cyclicality than the tech sector. Communication services should also be defined as cyclicals, although it is less of a clear cut than for the other sectors since the adjusted beta coefficient is the culprit behind the negative sign. Taking a closer look at the GICS2 sector level once again provides valuable insight. The computed mean correlation for cyclical GICS2 sectors is 0.34, with a variance of 0.04 and standard deviation of 0.2. For defensive GICS2 sectors, the computed mean correlation is -0.23, with a variance of 0.02 and a standard deviation of 0.13. Assessing This New Approach Having reclassified the GICS2 sectors as cyclicals or defensives, the next step is to assess how this approach performs compared to the MSCI definition of cyclicals/defensives. To do so, we use the average coefficients displayed on Table 4B to create a dynamic basket of cyclicals and defensives GICS2 sectors. These baskets are weighted by market capitalization and are updated monthly. Chart 6New Baskets Of Cyclicals/Defensives Chart 6 shows how the novel cyclical vs. defensives performs over time in the Euro Area relative to the other definitions. Next, we perform a simple back-testing exercise to assess the performance over time of the new cyclicals-to-defensives ratio, with the Global Manufacturing PMI as a control variable. A superior definition of cyclicals vs. defensives should lead to a better performance of cyclicals when the PMI is above its 50 boom/bust line and improving, and to a better performance of defensives when the PMI is below 50 and deteriorating. We look at coincident equity returns (Table 5A). Overall, the results indicate that our new approach is superior and more accurate, both on a 3- and 12-month time horizon. This is especially true when the global economy is deteriorating. When the PMI is below 50 and falling, our basket of defensives outperforms our basket of cyclicals on average by 20% on a 12-month horizon, compared to 14% using the MSCI definition. Table 5AAssessing The Performance (I) The subsequent performance of cyclicals relative to defensives following certain thresholds for the PMI also reinforces our new approach (Table 5B). Interestingly, our new basket of defensives is the only one to outperform cyclicals twelve months after the Global Manufacturing PMI deteriorated over several months and is below 50. Table 5BAssessing The Performance (II)​​​​​​​ Bottom Line: We are introducing a new approach to defining cyclical versus defensive equities. GICS1 sectors are too broad to achieve an accurate definition of cyclicality. However, the GICS2 classification offers the necessary level of granularity to do so. Moreover, we broaden the set of variables used to determine whether a GICS2 sector is cyclical or defensive. This new approach offers tighter links with the state of the global economy when selecting cyclical or defensive portfolio biases. For now, since EM economies and China remain under duress and the USD has yet to roll over clearly, we maintain our preference for defensive stocks over their cyclical counterparts within equity portfolios.   Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Amr Hanafy Associate Editor AmrH@bcaresearch.com Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     Applied Research MSCI, “Index Performance in Changing Economic Environments,” 2014, p. 4. 2     Admittedly, communications services – formerly known as telecommunication services – was removed from the list of defensive sectors and classified as a cyclical one following the 2018 GICS structure adjustment. 3    In the remainder of the report, the relative equity performance of European sectors is measured against the ACW index. 4    We normalized the beta coefficients to have a mean of zero, to be comparable with correlation coefficients.

Listen to a short summary of this report.     Executive Summary Euro Bulls Are Evaporating The euro is likely to undershoot in the near term, as the winter months approach and economic volatility in Europe rises. However, much of the euro’s troubles are well understood and discounted by financial markets. This suggests a floor closer to parity for the EUR/USD. Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year. The forces pressuring equilibrium rates lower in the periphery are slowly dissipating. That should lift the neutral rate of interest in the entire eurozone. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro, but that could change. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Long EUR/GBP 0.846 2021-10-15 -0.13 Short EUR/JPY 141.20 2022-07-07 2.46 Bottom Line: The euro tends to be largely driven by pro-cyclical flows, which will be a positive when risk sentiment picks up. Meanwhile, making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond. Our current stance is more measured because investors could see capitulation selling in the coming months. Feature Chart 1Two Decades After The Creation Of The Euro The creation of the euro was an ambitious project. It began with a simple idea – let’s create the biggest monetary union and everything else will follow, not least, economic might. Over the last two decades, the euro has survived, but its ambitions have been jolted by various crises. Today, the euro is sitting around where it was at the initiation of the project (Chart 1). That has been a tremendous loss in real purchasing power for many of its citizens. Given that we are back to square one, this report examines the prospects for the euro from the lens of its original ambitions, while navigating the economic and geopolitical landscape today. Surviving The Winter Chart 2A European Recession Is Well Priced In Winter will be tough for eurozone citizens. But how tough? In our view, less than what the euro is pricing in. According to the ZEW sentiment index, the eurozone manufacturing PMI should be around 45 today, but sits at 49.8. The euro, which has been tracking the ZEW index tick-for-tick has already priced in a deep recession, worse than the 2020 episode (Chart 2). Bloomberg GDP growth consensus forecasts for the eurozone are still penciling in 2.8% growth for 2022, down from a high of 4%. For 2023, forecasts have hit a low of 0.8%. It is certainly possible that euro area growth undershoots this level, which will cause a knee jerk sell off in the euro. However, much of the euro’s troubles are well understood and discounted by financial markets. Natural gas storage is already close to 80%, the EU’s target, to help the eurozone navigate the winter. Coal plants are firing on all cylinders, and Germany has decided to delay the closure of its nuclear power plants. It is true that electricity prices are soaring, but part of the story has been weather-related, notably a heat wave across Europe, falling water levels along the Rhine that has delayed coal shipments, and lower wind speeds that have affected renewable energy generation. France is also having problems with nuclear power generation, due to little availability of water for cooling reactors. Looking ahead, energy markets are already discounting a steep fall in prices from the winter energy cliff (Chart 3). If that turns out to be true, it will be a welcome fillip for eurozone growth. First, it will ease the need for the ECB to tighten policy aggressively, and second, it will boost real incomes, which will support spending. This is not being discussed in financial markets today. Chart 3AFutures Markets Suggest The Energy Crunch Will Ebb Chart 3CFutures Markets Suggest The Energy Crunch Will Ebb Chart 3BFutures Markets Suggest The Energy Crunch Will Ebb Fiscal Policy To The Rescue? Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year (Chart 4). As funds from the next generation EU plan are being disbursed into strategic sectors, including renewable energy, Europe’s productive capital base will also improve. This is likely to have a huge multiplier effect on European growth. Chart 4AThe Fiscal Drag In The Eurozone Could Be Minimal Chart 4BThe Fiscal Drag In The Eurozone Could Be Minimal Taking a bigger-picture view, what has become evident in recent years is stronger solidarity among eurozone countries, both economically and politically. Related Report  Foreign Exchange StrategyMonth In Review: Inflation Is Still Accelerating Globally Economically, the standard dilemma for the eurozone was that interest rates were too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. As such, the euro was often caught in a tug of war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The good news is that for the eurozone, a lot of this internal rupture has been partly resolved. Labor market reforms have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract since 2008. This has effectively eliminated the competitiveness gap with Germany, accumulated over the last two decades (Chart 5). Italy remains saddled with a rigid and less productive workforce, but the overall adjustments have still come a long way to close a key fissure plaguing the common currency area. The result has been a collapse in peripheral borrowing spreads, relative to Germany (Chart 6). Ergo, interest payments as a share of GDP are now manageable. It is true that Italy remains a basket case but the ECB’s Transmission Protection Instrument (TPI) will ensure that peripheral spreads remain well contained and a liquidity crisis (in Italy) does not morph into a solvency one. Chart 5The Periphery Is Now Competitive Chart 6Peripheral Spreads Are Still Contained In Real Terms Beyond the adjustment in competitiveness, productivity among eurozone countries might also converge. Our European Investment Strategy colleagues suggest that the neutral rate is still wide between Germany and the periphery. That said, gross fixed capital formation in the periphery has been surging relative to core eurozone members (Chart 7). If this capital is deployed in the right sectors, it will have two profound impacts. First, the neutral rate of interest in the eurozone will be lifted from artificially low levels. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates lower in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire eurozone. Over a cyclical horizon, this should be unequivocally bullish for the euro. Second, and more importantly, economic solidarity among eurozone members will help ensure the survival of the euro, over the next decade and beyond. Chart 7The Periphery Could Become More Productive Trading The Euro The above analysis suggests long-term investors should be buying the euro today. However, the long run can be a very long time to be offside. Our trading strategy is as follows: Over the next 6 months, stay neutral to short the euro. The economic landscape for the eurozone remains fraught with risk. This is a typical recipe for a currency to undershoot. Eurozone banks are very sensitive to economic conditions in the eurozone, and ultimately the performance of the euro, and the signal from bank shares remains negative (Chart 8). Chart 8European Banks Are Not Part Of The Agenda Watch Eurozone Banks Investors have been cutting their forecasts for the euro but have not yet capitulated. Bets are that the euro will be at 1.10 by the end of next year, and 14% higher in two years. A bottom will be established when investors cut their forecasts below current spot prices (Chart 9). This corroborates with data from net speculative positions that have yet to hit rock bottom.  Chart 9Euro Bulls Are Evaporating Real interest rates in the euro area are still plunging across the curve, relative to the US. The two-year real yield has hit a cyclical low. Five-year, 10-year and 30-year real yields are also falling. Historically, the euro tends to trend higher when interest rate differentials are moving in favor of the eurozone (Chart 10). Chart 10AReal Rates Are Dropping In The Euro Area Chart 10BReal Rates Are Dropping In The Euro Area Hedging costs have risen tremendously, as the forward market (like investors) is already pricing in an appreciation in the euro. The embedded two-year return for EUR investors is circa 4%, in line with the carry costs (Chart 11). In real terms, the returns are closer to 9% to compensate for much higher inflation expectations in the eurozone. Higher hedging costs will dissuade foreign investors from gobbling up European assets on a hedged basis. Chart 11A 5% Rally In The Euro Is Already Anticipated In short, the euro is likely to enter a capitulation phase. Our sense is that that it will push EUR/USD below parity, towards 0.98. Below that level, we believe the risk/reward profile will become much more attractive for both short- and longer-term investors. Signals From External Demand Chart 12The Euro Is Increasingly Dependant On Chinese Data The eurozone is a very open economy. Exports of goods and services represented 51% of euro area GDP in 2021. This means that what happens with external demand, especially in the US, the UK and China, matters for European growth (Chart 12). Of all its major export partners, China is the biggest question mark. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro. Historically, the Chinese credit impulse has been a good coincident indicator for EUR/USD. Lately, that relationship has decoupled (Chart 13A). We favor the view that the credit transmission mechanism in China is merely delayed, rather than broken. For one, a rising Chinese credit impulse usually leads European exports, and this time should be no different. Chinese bond markets are also becoming more liberalized, and as such are a key signal for financial conditions in China. For over a decade, easing financial conditions have usually been a good signal that import demand is about to improve (Chart 13B). This is good news for European export demand. The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when a few green shoots are emerging for external demand. That may not save the euro in the near term but will be a welcome fillip for euro bulls when it does undershoot. Chart 13AThe Muse For The Euro Is Chinese Data Chart 13BThe Muse For The Euro Is Chinese Data Concluding Thoughts Chart 14The Goldilocks Case For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts are aggressively revising up their earnings estimates for eurozone equities, relative to the US. They might be wrong in the near term, but over a 9-to-12-month horizon, this has been a good leading indicator for the euro.  Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond (Chart 14). Meanwhile, beyond the winter months, inflation could come crashing back to earth in the eurozone, which will provide underlying support for the fair value of the currency. Our near-term stance is more measured because investors are only neutral the euro, and risk reversals are not yet at a nadir. This is particularly relevant given that Europe still has a war in its backyard, with the potential of generating more market volatility ahead. Given this confluence of factors, we have chosen to play euro via two channels: Long EUR/GBP: As we argued last week, the UK has a bigger stagflation problem compared to the eurozone. This trade is also a bet on improving economic fundamentals between the eurozone and the UK, as well as a bet on policy convergence between the two economies. Short EUR/JPY: The yen is even cheaper than the euro. In a risk-off environment, EUR/JPY will sell off. In a risk-on environment, the yen can still benefit since it is oversold. Meanwhile, investors remain bullish EUR/JPY. Long EUR/USD: We will go long the euro if it breaks below 0.98.   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

Special Report

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Executive Summary Russia’s Crude Oil Output Will Fall Russia will have to lower oil production to ensure output it hasn’t placed with non-EU buyers does not tax its limited storage facilities, ahead of the bloc’s December 5 embargo. The EU’s insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonight’s close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russia’s Crude Oil Output Will Fall Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EU’s embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russia’s crude sales last month – ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russia’s seaborne crude oil sales, according to Bloomberg data. Related Report  Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end – vs its current output of 10.6mm b/d output presently – and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSA’s max capacity is 12mm b/d, while the UAE’s is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producers’ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply Chart 3Spare Capacity Concentrated In Core OPEC 2.0 Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand – particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year – +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand – the US and Europe – show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level – even with China’s negative y/y growth – while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track – it excludes the market-share wars of 2015-17 and that of 2020, and the pandemic’s effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after they’ve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EU’s embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will push crude oil prices higher and inventories lower (Chart 7).3  Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonight’s close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate inventories – diesel and heating oil mostly – were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the People’s Bank of China’s decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 Chart 9     Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloyd’s List 9 August 2022. The report notes, “All the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.“ 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary Then And Now Investors are fixated on inflation; for now, the peak in US CPI is a positive for global stocks. However, this tailwind could easily transform into fear if inflation becomes deflation. The risk of deflation is greater than investors currently appreciate. In the early 1920s, the policy-driven inflation of World War One quickly morphed into a violent deflationary shock, which prompted a severe bear market. Even in the absence of the gold standard, many contemporary factors parallel those that were apparent before 1921. As a result, if commodity prices do not stabilize by year-end, investors will start to worry about deflation. This fear could prompt another sell-off in stocks, which would be particularly painful in Europe. Buy protection against deflation while it is cheap by selling EUR/JPY. Continue to favor defensive over cyclical equities. Bottom Line: The deflation risk for 2023 is greater than the investment community currently appreciates. While it remains a tail risk, it is an underpriced one. As a result, investors should use the current rebound in stocks to buy protection against deflation.     Last week, the NASDAQ entered a new bull market following a decline in US inflation. European stocks have rallied too, albeit considerably less so, only rising 12.5% since their July 5th low. We have participated in this rally, having taken a more constructive view on European equities and other risk assets since our return from a trip visiting clients in Europe. Related Report  European Investment StrategyQuestions From The Road The decline in US inflation is likely to remain a tailwind for global equities in the near future. The pandemic-related factors that spiked inflation in the past quarters are ebbing, and commodity inflation is decreasing. However, BCA’s US bond strategists expect this window to be short-lived. Labor market tightness and strong rents suggest that core CPI will stabilize around 4%. Nonetheless, as long as this window is open, stocks should remain bid. Investors expecting the demise of this current rebound continue to pin their view on stubborn inflation. While sticky inflation is an undeniable risk, it is a threat well understood by the market. However, another danger lurks, which is much less appreciated by investors: deflation. Investors currently underestimate its odds, when deflation could prove even more damaging to the market than sticky inflation. Remembering 1921 Chart 1The 1921 Bear Market The most famous period of deflation in US economic history is the Great Depression. This is not, however, an appropriate parallel. The 1921 recession, at which time deflation hit a historical low of 16% per annum, is the more direct potential equivalent to today. It was accompanied by a 47% crash in the market that brought the Shiller P/E to five (Chart 1, top panel). At the end of WWI, the stock market experienced a rapid rally, with the Dow Jones jumping 58% from its low in March 1918 to its peak in November 1919. In that time frame, inflation was robust, with headline CPI averaging 16% between 1917 and 1920. Inflation was high because of a combination of factors: The war had forced a substantial loosening of fiscal policy with the Federal debt rising from 2.7% of GDP in 1916, before the entry of the US in the conflict, to 32.9% in 1921. The money supply experienced an unprecedented surge. At the beginning of the war, the US was a neutral party and European powers purchased large quantities of US goods. The resulting trade surplus pushed the US stock of gold from $1.5bn in 1914 to $2.6bn in 1920. Meanwhile, to help finance the government’s wartime expenditures, the newly created Federal Reserve expanded its banknote issuance and its claims on the banking system, which meant that Fed money rose from 21% of high-power money in April 1917 to 59% by November 1918. As a result of these two concurrent trends, the money supply doubled between 1916 and June 1920. The Fed was slow to remove the accommodation. The New York discount rate, which had fallen from 6% to 4% as war broke out in Europe, was only increased to 4.75% in the Spring of 1918 and stayed there until January 1920. The global economy was facing potent supply constraints. Large swaths of the European capital stock had been destroyed by the war, at the same time as the US economy had been redesigned to supply military goods, not consumer goods. As a result, inflation remained perky in 1919 and 1920, despite the end of the conflict. The fiscal and monetary supports suddenly ended in 1920, and the economy entered a vicious contraction that caused industrial production to plunge by 36% in 1921 and deflation to hit 16% (Chart 1, second and third panel). The fiscal easing suddenly shifted toward fiscal rectitude under the administration of Warren Harding, which greatly hurt domestic demand in 1921. Additionally, the inflow of gold from the war period morphed into outflow, as European powers enjoyed trade surpluses after their currencies fell 60% to 30% against the dollar between 1919 and the start of 1921. Moreover, the Fed increased the discount rate to 6% in 1920 and cut back the ratio of Fed money to gold, which caused M2 to swing from a 20% growth annual growth rate in Q1 1920 to a 7% contraction in Q3 1921. Simultaneously, corporate borrowing rates soared (Chart 1, fourth and fifth panel) The shock of stagflation and the associated deep output contraction caused the Dow Jones to collapse by 47% from late 1919 to August 1921. The market only stabilized once deflationary pressures ebbed, after the Fed had cut back the discount rate to 6% and around the same time when commodity prices began to firm up. By the end of the bear market, the reconstituted S&P 500 was trading at a cyclically-adjusted P/E of 5.2, and profits had fallen 81% from their 1916 peak. Bottom Line: The 1921 bear market was one of the most violent of the twentieth century. It was caused by an economic contraction and deep deflation that engulfed the US economy after the monetary and fiscal support of WWI had been removed. It only ended once deflationary forces began to ebb, after commodity prices found a floor. What Are The Parallels? At first glance, the parallels between 1921 and today seem negligible. Yes, inflation was raging in 1920, but deflation was a direct consequence of the gold standard that forced a rapid contraction in high-powered money, especially as gold fled the US in 1921. Chart 2Inflationary Fiscal And Monetary Policy The similarities, however, are remarkable too. As a result of the COVID-19 pandemic, the economy was subjected to similar conditions as that of the US around WWI. The US economy witnessed a massive explosion of fiscal stimulus that pushed the Federal deficit from 5% in 2019, to 10% and 6% of GDP in 2020 and 2021, respectively. Moreover, the Federal Reserve generated extremely accommodative monetary conditions during and after the pandemic, when its balance sheet more than doubled and M2 grew by 41% (Chart 2). Additionally, the global economy has witnessed extraordinary supply-side disruptions that have added to inflationary pressures created by the extreme push to aggregate demand from fiscal and monetary policy.1 Chart 3The Money Supply Is Contracting However, as in 1921, these forces are moving in the opposite direction. The fiscal thrust in the US was deeply negative in 2021 and 2022, when fiscal policy subtracted 4% and 2% from GDP growth, respectively. Moreover, the Fed’s policy tightening campaign is exceptionally aggressive. The Fed has increased rates by 2.25% in five months, and, based on the OIS curve, will push up interest rates by an additional 1.3% by the year-end (Chart 3). As a result, the recent contraction in M2 has further to run, even if the US economy is not constrained by its golden tethers (Chart 3, bottom panel). Between 1920 and 1921, investors had trouble judging how far the Fed would tolerate money contraction, which is again the case. Chart 4The Dollar Is Deflationary While the gold standard has been dissolved, the recent wave of dollar strength creates deflationary forces that are similar to the bullion anchor in the 1920s. In the US, the strength in the dollar is limiting imported inflation. US import prices have rolled over, a trend likely to continue. Once converted in USD, Chinese PPI is almost contracting today, which is no small matter when China is the marginal supplier of goods for the world (Chart 4). A strong dollar is deflationary for the global economy, not just that of the US. A rising greenback hurts commodity prices and also tightens global liquidity conditions. Already, the dollar-based liquidity is contracting and EM FX reserves – which are a form of high-powered money similar to gold flows in the 1920s – are tanking, even after adjusting for the confiscation of Russian reserves in the wake of the Ukrainian conflict (Chart 4, bottom panel). To defend their currencies as the dollar rallies, EM central banks are forced to tighten policy, which hurts their domestic economies. This phenomenon is also visible in advanced economies. The weak euro has played a role inching the ECB toward aggressive rate hikes, while the Riksbank and the Swiss National Bank are both lifting interest rates to fight the inflationary impact of their currencies falling against the greenback. Global supply constraints are also defusing. The price of shipping commodities and goods around the world is declining meaningfully (Chart 5). Meanwhile, deliveries by suppliers are accelerating globally, which is contributing to a very rapid easing of our indicator of US Supply Constraints (Chart 5, bottom panel). Beyond these parallels with the early 1920s, demand is already weakening globally. Hampered by the current rise in living costs, households have begun to reduce the volume of goods they purchase, while companies have maintained robust production schedules. As a result, inventories are swelling around the world (Chart 6). Historically, the best cure for elevated inventories is lower prices. Chart 5Easing Supply Constraints Chart 6Inventories And Weak Demand Are Deflationary Bottom Line: There is no guarantee that deflation will become the prevailing force in the global economy. However, the risk is there—and this threat is woefully underappreciated by the investment community. At this current juncture, investors are welcoming lower commodity prices as they take the edge off ebullient inflation. However, if commodity prices do not stabilize by year-end, then investors will begin to worry about deflation. As the 1921 experience showed, deflation is very painful for stocks because it is so negative for profits. While the absence of the gold standard means that the deep deflation of 1921 is extremely unlikely, a period of deflation would nonetheless have a very negative impact on stocks, since they trade at 29 times cyclically-adjusted earnings, not 6.2 times, as was the case in November 1919. What Does This Mean For European Assets? A bout of global deflation would be especially painful for European equities. European equities are more cyclical than their US counterparts, which means that they often underperform when global growth is weak and global export prices of manufactured goods are falling (Chart 7). In other words, a deflationary shock in the US would be felt more acutely in the European market than in that of the US. Additionally, the euro would likely weaken further. Already, the European money impulse (the change in M1 flows) is contracting, which augurs poorly for European economic activity (Chart 8). The addition of a deflationary shock to the weak domestic backdrop would prompt further outflows from Europe, which would hurt the euro even more. Chart 7European Stocks Hate Deflationary Busts Chart 8European Activity Is Weak Chart 9A Value Trap? Finally, with respect to the European cyclicals-to-defensive ratio, our Combined Mechanical Valuation Indicator suggests that European cyclicals have purged their overvaluation relative to their defensive counterparts (Chart 9). However, in previous deflationary outbreaks such as those in 1921 or the 1930s, cyclicals deeply underperformed defensive equities, no matter how cheap they became. This time around, we would expect the same outcome from cyclicals. Moreover, even if investors do not price in a deflationary risk early next year, European cyclicals remain hampered by the deceleration in the Chinese economy and the energy rationing that will hit Europe this winter. As a result, we continue to fade any rebound in the European cyclicals-to-defensives ratio. Bottom Line: Even if a deflationary shock is a risk that is more likely to emanate from the US, European markets will not be immune. The European economy is already weak, and the cyclicality of European equities creates greater vulnerability to deflation. Thus, while deflation in 2023 is a tail risk, investors should use the current rebound in global risk assets to buy protection cheaply. Selling EUR/JPY and favoring defensive European markets continue to make sense in light of this risk.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1Another similarity is that the Spanish Flu was decimating the population from late WWI to 1921.   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.     Executive Summary Chart 1The Dollar Has Broken Below The First Line Of Support The softer CPI print in the US boosted growth plays and pushed the DXY index below its 50-day moving average (Feature Chart). This suggests CPI numbers will remain the most important print for currency markets in the coming weeks and months. If US inflation has peaked, then the market will price a less aggressive path for Fed interest rates, which will loosen support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation. This will keep them on a tightening path. This puts the DXY in a tug of war. On the downside, the Fed could turn less hawkish. On the other hand, currencies such as the EUR, GBP and even SEK face high inflation but deteriorating growth. This will depress real rates. Within this context, the most attractive currencies are those with relatively higher real rates, and a real prospect of a turnaround in growth. NOK and AUD stand out as potential candidates. Our short EUR/JPY trade has been performing well in this context. Stick with it.  RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 141.20 2022-07-21 3.29 Bottom Line: Our recommended strategy is a neutral dollar view over the next three months, until it becomes clear inflation has peaked and global growth has bottomed. Feature The DXY index peaked at 108.64 on July 14 and has dropped to 105.1 as we go to press. There have been two critical drivers of this move. First, the 10-year US Treasury yield has fallen from 3.5% to 2.8%. With this week’s all important CPI release, which showed a sharp deceleration in the headline measure, bond yields may well stabilize at current levels for a while. Second, the drop in energy prices has boosted the JPY, SEK and EUR, which are heavily dependent on imported energy. Related Report  Foreign Exchange StrategyA Montreal Conversation On FX Markets Another development has been happening in parallel – as US inflation upside surprises have crested, so has the US price impulse relative to its G10 counterparts (Chart 1). To the extent that this eases market pricing of a hawkish Fed (relative to other G10 central banks), it will continue to diminish upward pressure on the dollar. Much will depend on the incoming inflation prints both in the US, and abroad. With the DXY having broken below its 50-day moving average, the next support level is at 103.6. This is where the 100-day moving average lies, which the dollar tested twice this year before eventually bouncing higher (Chart 2). The next few sections cover the important data releases over the last month in our universe of G10 countries, and implications for currency strategy. What is clear is that most foreign central banks are committed to their tightening campaign, which argues for a neutral stance towards the DXY for now. Chart 1US Inflation Momentum Has Rolled Over Chart 2The Dollar Has Broken Below The First Line Of Support US Dollar: Consolidation Chart 3The Conditions For A Fed Hike Remain In Place The dollar DXY index is up 10% year to date. Over the last month, the DXY index is down 2.1% (panel 1). Incoming data continues to make the case for a strong dollar. Job gains are robust. In June, the US added 372K jobs. The July release was even stronger at 528K jobs. This pushed the unemployment rate to a low of 3.5% (panel 2). Wages continue to soar. Average hourly earnings came in at 5.2% year-on-year in July. The Atlanta Fed wage growth tracker continues to edge higher across all income cohorts (panel 3). The June CPI print was above expectations at 9.1% for headline, with core at 5.9%. The July print for headline that came out this week was 8.5%, below expectations of 8.7%. At 5.9%, the core measure is still well above the Fed’s target (panel 4). June retail sales remained firm, but consumer sentiment continues to weaken. While the University of Michigan current conditions index increase from 53.8 to 58.1 in June, this is well below the January 2020 level of 115. Correspondingly, the Conference Board consumer confidence index fell from 98.7 to 95.7 in July. On June 17, the Fed increased interest rates by 75bps, as expected. The US entered a second consecutive quarter of GDP growth contraction in Q2, falling by an annualized 0.9%. The ISM manufacturing index was flat in July suggesting Q3 GDP is not starting on a particularly strong foot. The Atlanta Fed Q3 GDP growth tracker is, however, printing 2.5%. Unit labor costs are soaring, rising 10.8% in Q2. This is sapping productivity growth, which fell 4.6% in Q2.  The key for the dollar’s outlook is the evolution of US inflation and the labor market. For now, inflation remains sticky, and wages are rising. Meanwhile, labor market conditions remain robust. This will keep the Fed on a tightening path in the near term. We initially went short the DXY index but were stopped out. We remain neutral in the short term, though valuation keeps us bearish over a long-term horizon. The Euro: A European Hard Landing Chart 4The Euro Is At Recession Lows The euro is down 9.2% year to date. Over the last month, the euro is up 2.7%, having faced support a nudge below parity. Incoming data continues to suggest weak economic conditions, with a stagflationary undertone: The ZEW Expectations Survey for July was at -51.1, the lowest reading since 2011 (panel 1). The current account remains in a deficit, at -€4.5bn in May. Consumer confidence continues to plunge. The July reading of -27 is the worst since the 2020 Covid-19 crisis (panel 2). Despite the above data releases, the ECB surprised markets by raising rates 50bps. CPI continues to surprise to the upside. The preliminary CPI print for July came in at 8.9%, well above the previous 8.6% print. PPI in the euro area was at 35.8% in June, a slight decline from the May reading (panel 3). The German Ifo business expectations index fell to 80.3 in July. Historically, that has been consistent with a manufacturing PMI reading of 45 (panel 4). The Sentix confidence index stabilized in August but remains very weak at -25.2. This series tends to be trending, having peaked in July last year. We will see if the next few months continue to show stabilization. The ECB mandate dictates that it will continue to fight soaring inflation. As such, it may have no choice but to generate a Eurozone-wide recession. This is the key risk for the euro since it could push EUR/USD below parity again. We continue to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a risk-on environment, like this week, the yen can still benefit since it is oversold. Meanwhile, investors remain overwhelmingly bearish (panel 5). The Japanese Yen: Quite A Hefty Rally Chart 5Some Green Shoots In Japan The Japanese yen is down 13.4% year-to-date, the worst performing G10 currency (panel 1). Over the last month, the yen is up 3.3%. Incoming data in Japan has been worsening as the rising number of Covid-19 cases is hitting mobility and economic data. According to the Eco Watcher’s survey, sentiment among small and medium-sized Japanese firms deteriorated in July. Current conditions fell from 52.9 to 43.8. The outlook component also declined from 47.6 to 42.8. Machine tool order momentum, one of our favorite measures of external demand, continues to slow. Peak growth was at 141.9% year-on-year in May last year. The preliminary reading from July was at 5.5% (panel 2). Labor cash earnings came in at 2.2% year-on-year, a positive sign. Household spending also rose 3.5%. Rising wages could keep inflation momentum rising in Japan (panel 3). On that note, the Tokyo CPI report for July was also encouraging, with an increase in the core-core measure from 1% to 1.2%. The Tokyo CPI tends to lead nationwide measures. The labor market remains robust. Labor demand exceeds supply by 27%. The Bank of Japan kept monetary policy on hold on July 20th, a policy move that makes sense given incoming data. The BoJ still views a large chunk of inflation in Japan as transitory. For inflation to pick up, wages need to rise. While they are rising, inflation expectations remain well anchored, suggesting little rationale for the BoJ to shift (panel 4). That said, the yen is extremely cheap after being the best short this year (panel 5).  British Pound: Coiled Spring Below 1.20? Chart 6Cable Is Vulnerable The pound is down 9.8% year to date. Over the last month, the pound is up by 2.5%. Sterling broke below a soft floor of 1.20, but quickly bounced back and is now sitting at 1.22, as sentiment picked up (panel 1). We find the UK to have an even bigger stagflation problem than the eurozone. CPI came in at 9.4% in June. The RPI came in at 11.8%. PPI was at 24%. All showed an acceleration from the month of May (panel 2). Nationwide house price inflation has barely rolled over unlike other markets, increasing from 10.7% in June to 11% in July. The Rightmove national asking price was 9.3% higher year-on-year in July, compared to 9.7% in June (panel 3). Meanwhile, mortgage approvals have been in steady decline over the last two years, which points toward stagflation. Retail sales excluding auto and fuel fell 5.9% year-on-year in June, the weakest reading since the Covid-19 crisis. Consumer confidence is lower than in 2020 (panel 4). Trade data continues to be weak, which has dipped the current account towards decade lows (panel 5). The external balance is the biggest driver of the pound, given the huge deficit. The above environment has put the BoE in a stagflationary quagmire. Last week, they raised rates by 50 bps suggesting inflation is a much more important battle than growth. Politically, the resignation of Prime Minister Boris Johnson, and broader difficulties for the Conservative Party, is fueling sterling volatility. We are maintaining our long EUR/GBP trade as a bet that at 1.03, the euro has priced in a recession (well below the 2020 lows), but sterling has not. On cable, 1.20 will prove to be a long-term floor but it will be volatile in the short term.  Australian Dollar: A Contrarian Play Chart 7Relatively Solid Domestic Conditions In Australia The AUD is down 2.3% year-to-date. Over the last month, the AUD is up 5.3%. AUD is fast approaching its 200-day moving average. If that is breached, it could signal that the highs of this year, above 76 cents, are within striking distance (panel 1). Inflation is accelerating in Australia. In Q2, the inflation reading was 6.1%, while the trimmed-mean and weighted-median measures were above the central bank’s 1-3% band (panel 2). As a result, the RBA stated the benchmark rate was “well below” the neutral rate. It increased rates by an additional 50bps in August, lifting the official cash rate to 1.85%. Further rate increases are likely. There are a few reasons for this. First, labor market conditions are the most favorable in decades. In June, unemployment reached 3.5%, its lowest level in 50 years, against a consensus of 3.8% (panel 3). The participation rate also increased to 66.8% in June from 66.7%, which has pushed the underutilization rate to multi-decade lows (panel 4). Despite this, consumer confidence continued its decline in August, dropping to 81.2 from 83.8. A pickup in Covid-19 cases and high consumer prices are the usual suspects. Beyond the labor market, monetary policy seems to be having the desired effect. Demand appears to be slowing as retail sales grew 0.2% month-on-month in June from 0.9%. Home loan issuance declined by 4.4% in June, driven by a 6.3% decline in investment lending. House price growth continued to decline in July, particularly in densely populated regions like Sydney and Melbourne. The manufacturing sector remains strong, with July PMI coming in at 55.7, suggesting the RBA might just be achieving a soft landing in Australia.  The external environment was largely favorable for the AUD in June, as the trade balance increased substantially by A$17.7bn with commodities rallying early in the month. However, commodity prices are rolling over. The price of iron for example, is down 24% from its peak in June. This will likely weigh on the trade balance going forward (panel 5). A weakening external environment are near-term headwinds for the AUD, but we will be buyers on weakness (panel 6).  New Zealand Dollar: Least Preferred G10 Currency Chart 8Near-Term Risks To NZD The NZD is down 6.1% this year. Over the last month, it is up 5% (panel 1). The Reserve Bank of New Zealand raised its official cash rate (OCR) in July by 50bps to 2.5%, in line with market expectations. Policymakers maintained their hawkish stance and guided towards increased tightening until monetary conditions can bring inflation within its target range of 1-3%. Inflation rose in Q2 to 7.3% from a 7.1% forecast, largely driven by rising construction and energy prices (panel 2). As of the latest data, monetary policy appears to be continuing to have the desired effect on interest rate sensitive parts of the economy. REINZ home sales declined 38.1% year-on-year in June. Home price growth continues to roll over (panel 3). The external sector continues to slow. Dairy prices, circa 20% of exports, saw a 12% drop in early August after remaining flat in July. The 12-month trailing trade balance remains in deficit. This is most likely due to a substantial slowdown in Chinese economic activity, given that China is an important trade partner with New Zealand. What is important is that the RBNZ’s “least regrets” approach seems to be working. Despite a cooling economy, sentiment seems to be stabilizing. ANZ consumer confidence improved to 81.9 in July from 80.5. Business confidence also improved to -56.7 from -62.6 (panel 4). Ultimately, the NZD is driven by terms of trade, as well as domestic conditions (panels 1 and 5). Thus, short-term headwinds from a deteriorating external sector do not make us buyers of the currency for now, though a rollover in the dollar will help the kiwi.  Canadian Dollar: Lower Oil, Hawkish BoC Chart 9The BoC Will Stay On A Hawkish Path The CAD is down 1.2% year to date. Over the last month, it is up 1.8%. The Canadian dollar did not fully catch up to oil prices on the upside. Now that crude is rolling over, CAD remains vulnerable, unless the dollar continues to stage a meaningful decline (panel 1). Canadian data has been rather mixed over the last month. For example: There have been two consecutive months of job losses. This is after a string of positive job reports. In July, Canada lost 31K jobs. In June, it lost 43K. The reasons have been mixed, from women dropping out of the labor force, to lower youth participation (the participation rate fell), but this is a trend worth monitoring (panel 2). CPI growth remains elevated and is accelerating both on headline and core measures(panel 3). Building permits and housing starts have started to roll over, as house price inflation continues to lose momentum. June housing starts were at 274K from 287.3K. June building permits also fell 1.5% month-on-month though annual inflation is still outpacing house price growth (panel 4). The Canadian trade balance is improving, hitting a multi-year high of C$5.05 bn in June. This has eased the need for foreign capital inflows. The BoC raised rates 100bps in July, the biggest interest rate increase in one meeting among the G10. Unless the labor market continues to soften, the BoC will continue to focus on inflation, which means more rate hikes are forthcoming. The OIS curve is pricing a peak BoC rate of 3.6% in 9 months (panel 5). Two-year real rates are still higher in the US compared to Canada. And the loonie has lost the tailwind from strong WCS oil prices. As such, unless the dollar softens further, the loonie will remain in a choppy trading pattern like most of this year.  Swiss Franc: A Safe Haven Chart 10The Franc Will Remain Strong Against The Euro For Now CHF is down 3.2% year-to-date and up 4.3% in the past month. The Swiss franc has been particular strong against the euro, with EUR/CHF breaching parity (panel 1). Switzerland remains an island of relative economic stability in the G10. Although slowing, the manufacturing PMI was a healthy 58 in July. The trade surplus was up to CHF 2.6bn in June, despite a strong franc. While most European countries are preparing for a tough winter with energy rationing, prospects for Switzerland, which derives only 13% of its electricity from natural gas, look more favorable.  Still, as a small open economy, Switzerland is feeling the impact of global growth uncertainty. The KOF leading indicator dropped to 90.1 in August with a sharp decline in the manufacturing component. This broader measure suggests the relative resilience of the manufacturing sector might not last long (panel 2). Consumer confidence also fell to the lowest level since the onset of the pandemic. Swiss headline inflation stabilized at 3.4% in July. The core measure rose slightly to the SNB’s 2% target (panel 3). The UBS real estate bubble index rose sharply in Q2, suggesting inflation is not only an imported problem. Labor market conditions also remain tight, with the unemployment rate at 2%, a two-decade low. The SNB will continue to embrace currency strength while inflation risks persist (panel 4), as can be seen by the decline in sight deposits and FX reserves (panel 5). The market is still pricing in another 50 bps hike in September although August inflation data that comes out before the meeting will likely be critical for that decision. CHF is one of the most attractive currencies in our ranking. Despite the recent outperformance, CHF is still down year-to-date against the dollar. A rise in safe-haven demand, and a possible energy crunch in winter will be supportive, especially against the euro.  Norwegian Krone: Oil Fields Are A Jewel Chart 11NOK Will Reap Dividends From Energy Exports NOK is down 7.4% year-to-date and up 7.1% over the last month. It is also up 4.2% versus the euro, despite softer oil prices (panel 1). Inflation in Norway continues to accelerate. In July, CPI grew 6.8% year-on-year, above the market consensus and the Norges Bank’s forecast. Underlying inflation jumped sharply to an all-time high of 4.5%, compared to the Bank’s 3.2% forecast made just over a month ago (panel 2). These figures are adding pressure on the central bank to increase the pace of interest rate hikes, with 50bps looking increasingly likely at the meetings in August and September. NOK jumped on the inflation news. The housing market is starting to show signs of slowing with prices down 0.2% on the month in July, the first decrease since December. This, together with household indebtedness (panel 3), makes the task of policy calibration challenging. Our bias is that a persistently tight labor market and strong wage growth (panel 4) will allow the bank to focus on inflation. Economic activity remains robust in Norway but is softening. The manufacturing PMI fell to 54.6 in July, while industrial production was down 1.7% month-over-month in June. Consumer demand remains frail with retail sales and household consumption flat in June from the previous month. On a more positive note, trade surplus remains near record levels and is likely to stay elevated as high European demand for Norwegian energy is likely to last at least through the winter (panel 5). As global risk sentiment picked up, the krone became the best performing G10 currency over the past month. If the risk appetite reverses, the currency is likely to feel some turbulence. Swedish Krona: Cheap, But No Catalysts Yet Chart 12SEK = EUR On Steroids SEK is down 10% year-to-date and up 5.6% over the past month. The vigorous rebound highlights just how oversold the Swedish krona is (panel 1). The Swedish economy grew 1.4% in Q2 from the previous three months, rebounding from a 0.8% contraction in the first quarter. This is impressive, given high energy prices and a slowdown in global economic activity. Going forward, growth is likely to slow. In July, the services and manufacturing PMIs declined, and consumer confidence fell sharply to the lowest reading in almost 30 years. Retail sales were down 1.2% month-on-month in June. The housing market is also feeling the pain of rising borrowing costs (panel 2). The Riksbank’s latest estimate sees a 16% decline in prices by the end of next year.  For now, inflation is still accelerating in Sweden. CPIF, the Riksbank’s preferred measure, increased from 7.2% to 8.5% in June. Headline inflation rose from 7.3% to 8.7% (panel 3). Headline inflation is likely to decline in July, given the drop in the price component of the PMIs, but inflation will remain well above target. This will keep real rates weak (panel 4). This suggests that the Riksbank is facing the same conundrum as the ECB: accelerate policy tightening and tip the economy towards recession or remain accommodative and risk inflation becoming more entrenched. Our bias is that the Riksbank is likely to frontload rate hikes as currently priced in the OIS curve, with a 50 bps hike in September, ahead of major labor union wage negotiations (panel 5). Much like the NOK, the Swedish krona rebounded strongly in the past month on global risk-on sentiment. Fundamentally, the krona remains more vulnerable to external shocks due to higher energy dependency and a strong dollar. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets.  The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end.  In February 2023, another 800k b/d of refined products will be embargoed.  December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term.  Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months.  The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented.  A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil.  Even so, oil balances still will remain tilted to deficit conditions in 2023.  We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Chart 5Energy Driving High US Prices US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Chart 7…And Refining Capacity Are Bullish For Petrol Products There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Chart 10     Footnotes 1     Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2     Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3    Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022.  According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d.  In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4    Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5    Please see footnote #4. 6    The background factor in this situation is Russia’s involvement in Libya’s civil disorder.  We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7     Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8    Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9    Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10   After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11    Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12    For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis     Investment Views and Themes Strategic Recommendations Trades Closed in 2022