Currencies
Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years Chart 10NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
The US dollar was down across the board on Tuesday, and the DXY slipped to 89.79 – the lowest level since January 6th. This performance comes despite the latest data from the US Treasury International Capital (TIC) system which shows that inflows into US…
Highlights Global currencies are at a critical level versus the dollar. From a positioning standpoint today, a break below 89-90 on the DXY index will be extremely bearish, while a bounce from current levels should be capped in the 3-4% range. Two key factors have pushed the dollar down: lower real rates in the US and recovering economic momentum outside the US. There could be some seasonal strength in the dollar as equity markets churn in May. However, this will provide an opportunity for fresh short positions. The Federal Reserve will maintain its resolve to view the current inflation overshoot as transitory, while it will still focus on the labor market. This will keep real rates in the US depressed relative to other countries. New trade idea: Go long CHF/NZD as a play on rising currency volatility. Also sell USD/JPY if it touches 110. Feature Chart I-1The Dollar Is At A Critical Juncture After a brief rally from January to March, the dollar is once again on the verge of a technical breakdown. Both the DXY index, the Federal Reserve trade-weighted dollar and EM currency benchmarks are sitting at critical levels (Chart I-1). A breakdown will confirm that the dollar bear market that began in March 2020 remains intact. It will also trigger a flurry of speculative outflows from the dollar. In our December FX outlook,1 our view was that the DXY was headed towards 80 on a cyclical (12-18- month horizon). However, we also predicted the DXY index would hit 94-95 in the first quarter, a view we have reinforced multiple times since then. With the DXY index having peaked at 93.5, it is now instructive to explore the most likely next move. To do this, we will revisit what has changed and what has remained the same since our December piece. Gauging Investor Positioning Chart I-2Dollar Bulls Are Capitulating Going into 2021, selling the dollar was a consensus trade and the currency was very much oversold. For contrarians, it paid to be bullish (Chart I-2). Since then, investors have closed their short positions on the dollar, shifting their focus to JPY- and CHF-funded carry trades. Speculators are still long the euro, but the magnitude of this bet has declined from a net 30% of open interest to around 10% today. Positioning in GBP and CAD are still elevated, which suggests that these currencies remain vulnerable to a technical pullback. Interestingly, the Citigroup sentiment indicator for the USD is close to its January nadir. From the vantage point of this gauge, there has been an accumulation of dollar short positions in recent weeks. This helps explain recent dollar weakness. Going forward, positioning will not be particularly useful in dictating the next move in the dollar since it only works well at extremes. Even then, it is only useful for gauging countertrend moves. For much of the early 2000s, sentiment on the dollar was bearish yet rallies were capped at 4-6%. During last decade’s dollar bull market, sentiment remained mostly in bullish territory, but the dollar achieved escape velocity (Chart I-3). Chart I-3The Dollar And Regime Shifts From today’s positioning standpoint, a break below 89-90 on the DXY index will be an extremely bearish sign, while a bounce from current levels should be capped in the 3-4% range. This puts the greenback at a critical crossroad in technical terms. The Federal Reserve, Inflation And Interest Rates At the start of 2021, interest rates were moving in favor of the dollar, which continued a trend that has been in place since the middle of last year. The gap between the US and German 10-year yields rose from a low of around 100 basis points last year to a high of over 200 basis points in March. More recently, interest rate differentials have started to move against the dollar, explaining the broad reversal in dollar indices since March. The US-German 10-year spread now sits at 180 basis points. Exchange rates tend to reflect real interest rate differentials, since inflation erodes the purchasing power of a currency. As such, it is important to gauge not only what is happening to nominal rates, but also to underlying inflation trends. This complicates matters because inflation is often a lagging variable, so getting a sense of where inflation is headed can be greatly useful for currency strategy. As a starting point, the US does not rank well when it comes to real interest rates. Chart I-4 shows the broad correlation between real interest rates and the dollar. For low interest rate countries such as Switzerland, Sweden and the euro area, the peak in US real rates also coincided with a cyclical rebound in these currencies. Even for a currency such as the Japanese yen, real rates are favorable compared to the US. Nominal 10-year rates are 10bps and inflation swaps at the 10-year tenor are 23bps. This pins Japanese real rates almost 100bps above rates in the US. Chart I-4AInterest Rates Have Moved Against The Dollar Chart I-4BInterest Rates Have Moved Against The Dollar Chart I-4CInterest Rates Have Moved Against The Dollar Of course, with inflation surprising to the upside in the US, the Fed could taper sooner than they have communicated and/or raise interest rates faster than the market expects. This will not be surprising given other central banks such as the Bank of Canada and the Bank of England have already telegraphed reduced asset purchases. However, even if the Fed does decide to taper its asset purchases, the impact on the dollar will not be as straightforward as some market participants expect. To understand why, consider Chart I-5, which shows that relative to other central banks, the Fed’s balance sheet impulse is already shrinking by approximately 13% of GDP. In essence, the Fed has already been "stealthily" tapering asset purchases compared to other G10 central banks. This action supported the dollar this year. It has also pushed market pricing of the Fed funds rate well above the median dots of the FOMC in 2 years (Chart I-6). Thus the prospect of the Fed tapering asset purchases might already be embedded in the price of assets. Chart I-5Stealth Tapering By The Fed? Chart I-6Markets Have Already Priced A Hawkish Fed Going forward, our Global Fixed Income colleagues have noted that the Fed is already moving down the ladder in terms of who is expected to taper next.2 The Bank of Japan and the European Central Bank have barely tapered their asset purchases. They might not announce anything significant in their June 10 and June 18 meetings respectively, but markets will still be squarely focused on any change in language. Chart I-7A Profligate US Government Has Historically Been Dollar Bearish If investors decide to take the Fed’s messaging at face value, which suggests that the FOMC will look through any upside surprises in inflation, then real rates will remain depressed in the US—which will pressure the dollar lower. We have little conviction about whether US inflation is transient or more permanent. However, we do know that the US economy is more inflationary than most other developed markets because the US is stimulating domestic demand by much more than is required to close the output gap. Historically, this is a bearish development for the US dollar (Chart I-7). Economic Momentum As A Catalyst To the extent that monetary policy is tailored to suit domestic economic conditions, growth momentum is clearly rotating from the US to other countries. This suggests that the case for other central banks, such as the ECB or the RBA, to follow the steps of the BoE or BoC is rising at the margin. Manufacturing PMIs around the world have overtaken US levels, and it is only a matter of time before the services PMIs catchup. Chart I-8 shows that euro area data continues to surprise to the upside, with the economic surprise index between the euro area and the US at a decade high. This has historically been synonymous with modestly higher Eurozone bond yields relative to the US, which has also provided some support for the currency. The expectations component of both the ZEW and the Sentix surveys came out stronger this month, which confirms that both European and German growth should remain healthy over the summer (Chart I-9). Chart I-8Small Window For European Yields To RiseChart I-9Euro Area Data To Stay Strong As for the slowdown in Chinese stimulus, we agree it is a risk to global growth as our China Strategists highlight, but two opposing factors are also at play: Chinese stimulus leads the economy by a long lag. Last cycle, the apex of Chinese credit was in 2016, but it took until 2018 for global trade to slow down (Chart I-10). This partly explains why commodity prices have not relapsed, despite slowing credit creation from their largest buyer. An economy cannot rely on credit formation alone. At some point, the baton has to be passed to the forces of animal spirits. The velocity of money, or how many units of GDP are created for every unit of money creation, is one of these forces. Chart I-11 shows that the velocity of money has been rising faster outside the US, led by China. Chart I-10Chinese Credit Impulse Works With A Lag Chart I-11Money Velocity Versus The US The above trends give us conviction that any strength in the dollar is a countertrend move that should be faded until the Federal Reserve does a volte face and tightens monetary policy faster than they have telegraphed. A period of weak global growth would constitute another risk to our view. Interestingly, the Chinese RMB has hit new cyclical lows, despite a narrowing of interest rate differentials between the US and China. We suggested in our February Special Report that USD/CNY was headed for 6.2, even if interest rate differentials between the US and China narrowed. If Chinese economic activity is able to stay relatively robust despite slowing credit formation, then USD/CNY will decline further. Chart I-12EM Growth Remains Weak A break lower in USD/CNY is a necessary but not a sufficient condition for EM currencies to outperform. Relative to the US, EM growth remains worse than at the depths of the COVID-19 recession last year (Chart I-12). Our Emerging Market Strategists reckon a change in economic conditions will be necessary for EM currencies to outperform on a sustained basis. A broadening of the vaccination campaign toward EM countries is likely to hold the key to this change. The Real Risk To Dollar Short Positions The risk from shorting the dollar at current levels comes from the equity market. Developed market currencies have run ahead of the relative performance of their domestic bourses. This is a departure from historical correlations (Chart I-13). A reset in equity markets that favors defensive equities will lead to inflows into the US equity and bond markets, which will hurt DM currencies and buffet the dollar. It is worrisome that this earnings season, the US enjoyed stronger positive earnings revisions. Correspondingly, the US put/call ratio remains very depressed, with complacency reigning across most equity bourses (Chart I-14). Chart I-13ACurrencies Have Ran Ahead Of Equity Outperformance Chart I-13BCurrencies Have Ran Ahead Of Equity Outperformance Chart I-14Lots Of Exuberance In US Stocks Chart I-15Equities And The Dollar Have Diverged The nature of a potential market reset is important to consider. For example: Global equities correct, but technology and healthcare lead the drop. In this scenario, the dollar underperforms, as is happening now (Chart I-15) because the US has a heavy weighting in these defensive sectors. The reverse will happen if value stocks or cyclicals lead the drop in global equities. Global equities correct, but bond yields drop as well. The initial reaction will be a stronger dollar as US inflows accelerate, but this will also curb the appeal of the US dollar since Treasury yields will converge towards those of Bunds or JGBs. Moreover, US real rates will collapse even further. We will be sellers of the dollar on strength in this scenario. Global equities correct as yields increase. If US yields lead this rise, the dollar will rally at first, but outflows from the US equity market will also accelerate. If this rotation is durable, the dollar will eventually depreciate, because foreign bourses are highly levered to rising yields. In a nutshell, the US bond market offers attractive yields and the US stock market could behave defensively (as has historically been the case) in a market correction. This creates a risk to shorting the dollar today. Currency Strategy Currency markets are at a critical juncture (Chart I-1) where either a breakdown in the dollar or a countertrend reversal is imminent. Our strategy remains the same it has been so far in 2021. Continue to short the USD against a basket of the most attractive currencies. On this basis, we are already long the Scandinavian currencies. Go short USD/JPY given lopsided positioning. We are placing a limit sell on USD/JPY today at 110. We are also raising our limit buy on the euro to 1.18. It is interesting that the EUR/JPY cross broke out from a multi-year downtrend. This cross has an inverse correlation with the dollar. Buy CHF/NZD today as a play on rising currency volatility. This is a good bet as markets grapple with the next central bank taper policy (Fed versus other DM economies) (Chart I-16). Wait for the equity market correction to play out, after which a green light to short the dollar outright will once again emerge. Historically, May is a good month for the dollar and a volatile one for equities (Chart I-17). That said, dollar bear markets often run in long cycles. Chart I-16Buy CHF/NZD As Insurance Chart I-17The Dollar And Seasonality Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The recent data out of the US have been mixed: Average hourly earnings improved by 0.7% in April versus March, beating the expected 0.1% increase. Non-farm payrolls increased by 266K in April, far below the expected 978K and 770K in March. The unemployment rate worsened slightly from 6% in March to 6.1% in April, versus an expected improvement to 5.8%. The NFIB Small Business Optimism survey edged higher to 99.8 in April from 98.2 the prior month. CPI came in at 4.2% year on year in April, outpacing expectations of a 3.6% rise. Month on month, CPI grew by 0.8% in April, crushing the 0.2% consensus. Core CPI came in at 3% year on year in April, beating the expected 2.3%. PPI also surprised to the upside, clocking in at 6.2% year on year in April, versus an expected rise of 5.8%. The US dollar DXY index dropped by 1.3% this week. While CPI surged ahead, employment severely lagged expectations. The Fed’s “maximum employment” target, a gateway to any asset purchase tapering, is unlikely to be reached when the market expects it. This combination of persistent Fed dovishness and potential sizable inflation is bearish for the dollar. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been strong: March German imports strengthened by 6.5% month on month, crushing the expected 0.7%. German ZEW current condition registered at -40.1 in May, far ahead of the -48.8 in April. German ZEW economic sentiment also surprised to the upside in May at 84.4 versus the anticipated 72. For the entire euro area, the ZEW economic sentiment increased to 84 in May from 66 in April. Sentix investor confidence improved to 21 in May from 13.1 in April, beating the expected 14. Sentix investor expectations climbed to an all-time high of 36.8. The current situation crossed into positive territory for the first time since February 2020. March industrial production was up by 0.1% month on month, lower than the expected 0.7%. The euro strengthened by 1.3% this week against the USD. The uplifting ZEW survey results reinforce our expectation of a global growth rotation in favor of the euro area. While the ECB may not taper asset purchases, a forceful vaccination campaign should lead to further upside data surprises, especially in services. The Euro Area Economic Surprise Index (ESI) remains elevated in contrast with the US ESI, which has declined sharply from its July 2020 peak. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 There was scant data out of Japan this week: Household spending strengthened by 7.2% in March versus February, comfortably beating the expected 2.1% increase. The Japanese current account weakened to JPY 2.65tn in March from JPY 2.9tn in February. The Eco Watchers Survey disappointed in April, with current conditions declining from 49 to 39.1 and the expectations component falling from 49.8 to 41.7. The yen was up by 0.5% against the USD this week. The recent extension of the already months-long state of emergency will put downward pressure on the yen in the near term. However, with Japanese equities and the currency in oversold conditions, we are cautiously optimistic on the yen further along in the year. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data out of the UK have been weak: Construction PMI remained mostly unchanged at 61.6 in April. GDP weakened, quarter on quarter, by 1.5% in Q1. More disappointing was business investment that dropped in Q1 by 11.9% quarter on quarter and 18.1% year on year. March GDP strengthened by 2.1% month on month, suggesting the pullback in the first quarter was mostly due to lockdowns. Manufacturing production was up by 2.1% in March versus February, beating the 1% consensus. The trade deficit narrowed to GBP11.71B in March. The pound was up by 1.7% this week against the USD. The soft Q1 output data, primarily a result of the winter lockdown, mask improvements in March. With restrictions being lifted, services output and household consumption (induced by excess savings) should quickly catch up with the recent bounce in manufacturing. However, markets may have priced in too much of the UK’s vaccination outperformance as is reflected in the overpriced small-cap equities. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The recent data out of Australia have been positive: The NAB Business confidence increased to 26 in April from 17 the prior month. The NAB business survey index also edged higher to 32 in April from 25 in March. Retail sales increased by 1.3% in March month on month, slightly below the expected 1.4%. Quarter on quarter, Q1 retail sales weakened by 0.5% versus the estimated drop of 0.4%. Q1 CPI came in below expectations at 0.6% quarter on quarter and 1.1% year on year. The AUD was up by 1.2% this week against the USD. While the NAB business confidence and conditions indices came in at record highs, the price pressures remain weak in Australia and vaccination progress continues to lag. That said, leading indicators such as capex intentions and forward orders are improving. We are short AUD/MXN mainly to capitalize on Mexico’s proximity to the rebounding US. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data out of New Zealand have been scant: Electronic card retail sales increased by 4% month on month in April after a 0.8% drop in March. The food price index came in at 1.1% month on month in April, compared to 0% in March. The NZD was up by 0.8% this week against the dollar. With positive data coming out of New Zealand recently, our Global Fixed Income Strategy colleagues judge the RBNZ to be the next central bank most likely to taper sometime in the second half of 2021. However, with Q2 inflation expectations that remain soft and the tourism sector still held back by broad border shutdowns, we remain cautious on the kiwi. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been mildly disappointing: The employment report was disheartening. Canada lost 207.1K jobs in April, and the participation rate dropped from 65.2% to 64.9%. The unemployment rate also weakened from 7.5% to 8.1% in April, higher than expected. The Ivey PMI dropped to 60.6 in April from 72.9 in March, in line with expectations. The CAD was up by 1.35% against the USD this week. Despite the already months-long rallying of the loonie and the housing prices, the CAD is still cheap by its real effective exchange rate. Strengthening oil prices should continue to support the currency. A potential extension to the current COVID-19 lockdown and lagging vaccination progress remain downside risks. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent Swiss data have been neutral: Unemployment rate remained relatively unchanged at 3.3% in April, in line with expectations. The Swiss franc was up by 1% this week against the USD. The franc is cheap with a real effective exchange rate that is at one standard deviation below fair value. Should the pickup in global trade continue, this will buffet the franc. However, our bias is that the SNB will continue to fight excessive franc strength, especially against the euro. So we think the franc will lag the euro over the longer term. We are also going long CHF/NZD today should currency volatility pick up. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The recent data out of Norway have been mixed: CPI came in at 3% in April, in line with expectations. PPI growth registered at 22.5% in April, year on year. GDP dropped by 0.6% in Q1 quarter on quarter, a disappointment given an estimated 0.4% decrease. Mainland GDP also undershot expectations, decreasing by 1% in Q1 quarter on quarter. The NOK was up by 1% this week against the dollar. The soft Q1 data may hold back the NOK in the very near term, especially considering its remarkable performance since its March 2020 lows. That said, the rally in oil prices will continue to provide support to the NOK. Vaccination progress, on par with that of the euro area, should also benefit the currency. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent Swedish data have been mildly positive: The unemployment rate came down from 8.4% in March to 8.2% in April. CPI came in at 2.2% year on year and 0.2% month on month in April, in line with expectations. CPIF registered at 2.5% year on year and 0.3% month on month in April, both beating the consensus. The SEK was up by 2% this week against the USD. Vaccination progress in Sweden is only notches below that of the euro area. A potential shift of sentiment out of the crowded commodity-driven trades could also lend support to the export-driven SEK, on the back of a recovery in Europe in the near term. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2 Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8). Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
EM stocks, including Chinese equities, tend to perform well during periods of stronger global growth, rising commodity prices and a weaker US dollar. However, a falling dollar index since April has failed to boost Chinese investable stock prices. China’s…
Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis. Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks Table 3A Bullish Backdrop For EUR/USD The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9). Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February. The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More Chart 12Accelerating UK Inflation Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains. It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Chart 16Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades
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Highlights Sweden’s economic recovery is robust and will deepen. Policy is accommodative. Very few advanced economies will benefit as much from the global economic rebound. The labor market will tighten, capacity utilization will increase, and inflation will rise faster than the Riksbank forecasts. On a one- to two-year investment horizon, the SEK is a buy against both the USD and the EUR. Despite their pronounced outperformance, Swedish stocks possess significantly more upside against both Eurozone and US equities over the remainder of the cycle. Swedish industrials will beat their competitors in both these markets. Nonetheless, China’s policy tightening creates a meaningful tactical risk, which selling Norwegian stocks can hedge. Italy’s fiscal plan constitutes a new salvo in Europe’s efforts to avoid last decade’s mistakes. Feature Last week, the Swedish Riksbank did not follow in the footsteps of the Norges Bank. The Swedish central bank acknowledged that the economy is performing better than anticipated and that the housing market is gaining in strength; yet, it refrained from hinting at any forthcoming adjustment to its policy rate or the pace of its asset purchase program. The positive outlook for the Swedish economy will force the Riksbank to tighten policy significantly before the ECB. As a result, we expect the Swedish Krona to outperform the euro and the US dollar. Moreover, investors should continue to overweight Swedish equities due to their large exposure to industrials and financials, even if they have already significantly outperformed the Euro Area. Sweden’s Economic Outlook The Swedish economy will accelerate, which will put pressure on resource utilization and fan inflationary risk in the years ahead. The degree of stimulus supporting Sweden is consequential. Chart 1A Dual Labor Market On the fiscal front, the government support measures that have been announced since the beginning of the COVID-19 crisis currently amount to SEK420bn, or SEK197bn for 2020 (4% of GDP), and SEK223bn for 2021 (4.5% of GDP). Moreover, generous labor market protection and part-time employment schemes meant that the number of employees in permanent employment contracts remained stable during the pandemic (Chart 1). Thus, the bulk of the rise in Swedish unemployment came from workers on fixed-term contracts. Monetary policy remains very accommodative as well. The Riksbank left its repo rate unchanged at 0% through the crisis, but cut its lending rate from 0.75% to 0.1%. More importantly, the Swedish central bank is aggressively injecting liquidity into the economy. It set up a SEK500bn funding-for-lending facility in order to incentivize bank lending to the nonfinancial private sector, and started a SEK700bn QE program, which as of Q1 2021 had purchased SEK380bn securities and which will purchase another SEK120bn in Q2, with covered bonds issued by banks accounting for 70% of it. As a result, the amount of securities held on the Riksbank balance sheet will nearly triple by year end (Chart 2). Chart 2The Riksbank Is Open For Business Beyond the monetary and fiscal stimulus, many factors point to greater economic strength for Sweden. Despite a slow start to the process, as of last week, nearly 30% of the Swedish population had received at least one vaccine dose, which is broadly in line with vaccination rates prevalent in France or Germany. Crucially, the pace of vaccination is accelerating at a rate of 13% per week. Even if this second derivative slows, more than 70% of the population will have received at least one dose by this summer. Thus, greater mobility is in the cards during the second quarter, which will boost household spending. Chart 3The Wealth Effect The housing market also favors a pick-up in consumption. The HOX housing price index is growing at a 15% annual rate, its fastest expansion in over 5 years. As a result of the wealth effect, this rapid appreciation is consistent with a swift improvement in the growth rate of household expenditures (Chart 3). Moreover, spending on durable goods now stands 1.3% above its pre-pandemic levels, while spending on non-durables is back to pre-pandemic levels. This context suggests that increased mobility translates into greater spending. The industrial sector remains a particularly bright spot in the Swedish economy. Sweden is extremely sensitive to the global industrial and trade cycle, because exports represent 45% of GDP. Moreover, the highly cyclical intermediate and capital goods comprise 56% of the country’s foreign shipments, which accentuates the beta of the Swedish economy. BCA Research remains optimistic about the global industrial cycle. Sweden will reap a significant dividend. Already the Swedish PMI points to stronger industrial production, and the index’s exports component is roaring ahead (Chart 4). The potential for a greater uptake in consumption, capex, and durable goods spending in the rest of the EU (Sweden’s largest trading partner) bodes well for the Swedish manufacturing sector. Additionally, if the collapse in the US inventory-to-sales ratio is any indication for the rest of the world, a global restocking cycle is forthcoming, which will further boost Swedish industrial activity (Chart 4, bottom panels). Finally, global public infrastructure plans are on the rise, which will also help Sweden. Chart 4Sweden Is well Placed Chart 5Brightening Labor Market Prospects In this context, the Swedish labor market should tighten significantly in the approaching quarters. Already, job vacancies are rebounding, and redundancy notices have normalized, which matches both the GDP growth surprise in Q1 and the continued rise in the NIER Sweden Economic Tendency Indicator. Furthermore, the employment component of the PMIs stands at 58.9 and is consistent with a sharp improvement in job growth over the coming year (Chart 5). The expected labor market growth will contribute to an increase in capacity utilization, which will place upward pressure on wages and inflation. When the 12-month moving average of US and Eurozone imports rises, so does the Riksbank Resource Utilization Indicator, because global trade has such a pronounced effect on the Swedish economy (Chart 6). Meanwhile, greater resource utilization leads to accelerated inflation, greater labor shortages, and rising unit labor costs (Chart 7). Chart 6CAPU Will Rise Chart 7The Coming Pressure Buildup Bottom Line: As a result of generous stimulus and the global economic recovery, the Swedish economy is set to continue its rebound. Consequently, employment and capacity utilization will improve meaningfully, which will lead to a resurgence of inflation and wages in the coming 24 months. Investment Implications On a 12 to 24 months horizon, we remain positive on the Swedish krona and Swedish equities. Fixed Income And FX Chart 8Three Hikes By 2025 The backend of the Swedish OIS curve only discounts 75bps of hikes by 2025. This pricing is too modest (Chart 8). The Swedish economy will rebound further as the vaccination campaign advances, and rising house prices and household indebtedness will fan growing long-term risk to financial stability, both of which suggest that the Riksbank will have to change its tack in 2022. The great likelihood that the Fed will start tapering off its asset purchase toward the end this year, that the ECB will follow sometime in 2022, and that the Norges Bank will be increasing interest rates next year will give more leeway to the Swedish central bank. A wider Sweden/Germany 10-year government bond spread is not an appealing vehicle to play a more hawkish Riksbank down the road. This spread hit a 23-year high in March and now rests at 62bps or its 98th percentile since 2000. Moreover, the terminal rate proxy embedded in the German money market curve is currently so low that the spread between Sweden’s and the Eurozone’s terminal rate proxy stands near a record high. Hence, German yields already embed much more pessimism than Swedish ones. Nonetheless, BCA recommends a below benchmark duration exposure within the Swedish fixed-income space, as we do for other government bond markets around the world.1 A bullish bias toward the SEK is a bet on the Riksbank that offers a very appealing risk/reward ratio, according to BCA Research’s Foreign Exchange Strategy strategists.2 The krona is very cheap against both the euro and the US dollar, trading at 9% and 29% discounts to purchasing power parity, respectively. Moreover, the Swedish current account stands at 5.2% of GDP, compared to 2.3% and -3.1% for the Euro Area and the US, creating a natural underpinning under the SEK. Chart 9The SEK Loves Growth Over the coming 12 to 24 months, cyclical forces favor selling EUR/SEK and USD/SEK on any strength. The SEK is one of the most cyclical G-10 currencies and has one of the strongest sensitivities to the US dollar. Hence, our positive global economic outlook and our FX strategists negative view on the greenback are synonymous with a weak USD/SEK. These same factors also mean that the krona will appreciate more than the euro, as the negative correlation between EUR/SEK and our Boom/Bust Indicator and global earnings growth illustrate (Chart 9). Equities We also like Swedish equities, but the state of the Swedish economy and the evolution of the Riksbank policy surprise have a limited impact on Swedish equities. The Swedish bourse is mostly about the evolution of the global business cycle. The Swedish benchmark heightened sensitivity to the global business cycle reflects its massive overweight in deep cyclicals, with industrials, financials, consumer discretionary, and materials accounting for 38.4%, 26.1%, 9.7% and 3.7% of the MSCI index respectively, or 78% altogether (Table 1). As a result, BCA’s preference for global cyclicals at the expense of defensives and this publication’s fondness for the recovery laggards like the industrial and financial sectors automatically translate into a favorable bias toward Sweden’s stocks.3 Table 1Mamma Mia! That’s A Lot Of Cyclicals Valuations offer a more complex picture, but they do not diminish our predilection for Sweden. Swedish equities trade at a discount to US stocks but at a premium to Euro Area ones (Chart 10). However, Swedish stocks offer higher RoEs and profit margins than both the US and the Euro Area, while also sporting lower leverage (Chart 11). Thus, their valuation premium to Euro Area stocks is warranted and their discount to US ones is excessive, especially when rising yields hurt the relative performance of the growth stocks that dominate US indexes. Chart 10Swedish Discounts And Premia Chart 11Profitable Sweden The outlook for Swedish earnings is appealing, both in absolute and relative terms. The Swedish market’s extreme sensitivity to global economic activity means that Sweden’s EPS increase and beat US profits when the Riksbank Resource Utilization Indicator expands (Chart 12). These relationships are artefacts of the Swedish economy’s pro-cyclicality, which causes capacity utilization to interweave tightly with the global business cycle (Chart 6). Chart 12The Winner Takes It All Chart 13Better Capex Play Than You Global capex and infrastructure spending favor Swedish equities compared to Euro Area ones. Over the past thirty years, Sweden’s stocks have outperformed those of the Eurozone when capital goods orders in the advanced economies have expanded (Chart 13). This reflects the Swedish benchmark’s large overweight in industrials, a sector that is the prime beneficiary of global capex. Capital goods orders are recovering well, and their growth rate can climb higher, especially as western multinationals announce capex plans and as governments from the US to Italy intend to ramp up infrastructure spending. Moreover, the large pent-up demand for durable goods in the Eurozone further enhances the potential of industrial firms, and thus, of Swedish equities.4 Chart 14Another Sign Of Pro-Cyclicality BCA Research’s positive cyclical stance on commodities offers another reason to overweight Sweden’s market relative to that of the US and the Euro Area. Our Commodity and Energy Strategy sister service anticipates significant further upside for natural resources, especially base metals, over the remainder of the business cycle.5 Commodity prices still have room to rally, because demand will grow as the global economy continues to recover and because the supply of natural resources has been constrained by a decade of low investment. As a result, rising metal prices will symptomatize strong economic activity around the world and will incentivize capex in commodity extraction, both of which will boost the revenue of industrial firms. Furthermore, commodity price inflation often corresponds with rising yields, which boosts financials as well. These relationships explain the Swedish stocks’ outperformance of US and Eurozone stocks, when natural resource prices rally, despite the former’s low exposure to materials (Chart 14). At the sector level, the appeal of Swedish industrials relative to those of the Eurozone and the US completes the rationale to favor Swedish equities in a global portfolio. Swedish industrials are just as profitable as US ones and are more so than Euro Area ones, while having significantly lower leverage than either of them (Chart 15). Additionally, for the past two years, the EPS growth of Swedish industrials has bested that of US and Eurozone ones. Yet, their forward P/E ratio trades in line with the US and the Euro Area, while the sell-side’s long-term relative earnings growth estimate is too depressed (Chart 16). The same observations are valid when comparing Swedish industrials to French or German ones. Hence, in the context of a global business cycle upswing, buying Swedish industrials while selling their US and Euro Area competitors is an appealing pair trade, especially since it also involves short USD/SEK and short EUR/SEK bets. Chart 15Attractive Swedish Industrials... Chart 16...And Not Expensive Despite our optimism toward Swedish stocks on a 12 to 24 months basis, investors must hedge a near-term risk. Chinese authorities are aiming to contain financial excesses and trying to restrain credit growth. As we showed four weeks ago, China’s excess reserve ratio is contracting, which points toward a slowdown in the Chinese credit impulse.6 Historically, such a development can hurt global cyclicals, and thus, also Swedish equities. However, BCA Research’s China strategists believe that Beijing will not kill off the Chinese business cycle; thus, the recent disappointment in the Chinese PMI is transitory.7 Chart 17Industrials vs Materials: Europe vs China Materials more than industrials will suffer the brunt of a China slowdown, as the re-opening trade and capex cycle among advanced economies will create a buffer for the latter. Indeed, the performance of global industrials relative to materials stocks correlates with the evolution of the spread between the Euro Area and Chinese PMI (Chart 17). Thus, we recommend selling Norwegian equities to hedge the tactical risk inherent in an overweight on Sweden. As Table 1 above shows, Norway overweighs materials and energy (two sectors greatly exposed to China), hence, a temporary pullback in commodity prices should hurt Norwegian stocks more than Swedish ones. Bottom Line: The SEK is an inexpensive and attractive vehicle to bet on both the global business cycle strength and the Swedish economic recovery. Thus, investors should use any rebound in EUR/SEK and USD/SEK to sell these pairs. Moreover, Swedish stocks greatly overweight cyclical sectors, particularly industrials and materials. This sectoral profile renders Swedish equities as attractive bets on the global economy. Additionally, Swedish shares display alluring operating metrics. As a result, we recommend investors go long Swedish industrials relative to those of the US and Euro Area. They should also overweight Swedish equities against the US and the Eurozone. Consequent to some China-related tactical risks, an underweight stance on Norwegian stocks constitutes an attractive hedge to this Swedish exposure. A Few Words On Italy’s National Recovery And Resilience Plan Mario Draghi’s plan to revive the Italian economy, announced last week, is an important marker of Europe’s changing relationship with fiscal policy. Last decade, excessive austerity contributed to subpar growth, ultimately firing up concerns about debt sustainability in many peripheral economies, and fueled risk premia in Italy and Spain. Under the cover of the current crisis, and in the face of the changing political winds in Brussel and Berlin where fiscal rectitude is not the mantra it once was, national European governments are beginning to propose ambitious fiscal stimulus plans. The National Recovery and Resilience program illustrates these dynamics. The EUR248bn plan is a testament to the importance of the NGEU recovery program as well as the REACT EU recovery fund. Through these facilities, the EU will contribute EUR191.5bn to the fiscal plan via grants and loans. Italy will contribute the remainder of the funds. While the total amount disbursed over the next six years corresponds to 14% of Italy’s 2019 GDP, the Draghi government estimates that the program will add 3.2 percentage points to GDP between 2024 and 2026. Importantly, markets are not rebelling. Despite expectations that Italy would continue to run an accommodative fiscal policy, the BTP/Bund spreads remain stable. We can expect this trend of greater stimulus to be mimicked around the EU. Spain is another large recipient of the NGEU program, and it too is likely to increase stimulus beyond what the EU will fund. France will hold an election in May 2022, and President Macron has all the incentives to stimulate the economy between now and then. If, as we wrote last week, Germany shifts to the left in September, then this outcome will be guaranteed. Bottom Line: The Draghi plan is the first salvo of greater fiscal stimulus in the EU. This trend will help Eurozone growth improve relative to the US over the coming few years. Despite a loose fiscal policy, BTPs and other peripheral bonds will continue to outperform on the back of declining risk premia. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1Please see Global Fixed Income Strategy “GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening,” dated April 6, 2021, available at gfis.bcaresearch.com 2Please see Foreign Exchange Strategy “2021 Key Views: Tradeable Themes,” dated December 4, 2020, available at fes.bcaresearch.com 3Please see European Investment Strategy “Summer Of ‘21,” dated March 22, 2021, available at eis.bcaresearch.com 4Please see European Investment Strategy “Winds Of Change: Germany Goes Green,” dated April 23, 2021, available at eis.bcaresearch.com 5Please see Commodity & Energy Strategy “Industrial Commodities Super-Cycle Or Bull Market?” dated March 4, 2021, available at ces.bcaresearch.com 6Please see European Investment Strategy “The Euro Dance: One Step Back, Two Steps Forward,” dated March 29, 2021, available at eis.bcaresearch.com 7Please see China Investment Strategy “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021, available at cis.bcaresearch.com Cyclical Recommendations Structural Recommendations Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades