UK

Special Report

The BoE is the key to arrest the meltdown in UK assets, but will the malaise engulfing London only end up traveling to Rome?

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

Executive Summary For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. To reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. In the US, a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. This reiterates our ‘2022-23 = 1981-82’ template for the markets. A coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. It Now Costs Twice As Much To Buy Than To Rent A UK Home! Bottom Line: Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. Feature Mortgage rates around the world have skyrocketed. The UK 5-year fixed mortgage rate which started the year at under 2 percent has more than doubled to over 5 percent. And the US 30-year mortgage rate, which began the year at 3 percent, now stands at an eyewatering 7 percent, its highest level since the US housing bubble burst in 2008. This raises a worrying spectre. Is the recent surge in mortgage rates about to trigger another housing crash? (Chart I-1 and Chart I-2). Chart I-1UK Mortgage Rate Has Doubled Chart I-2US Mortgage Rate Has Doubled A good way to answer the question is to compare the cashflow costs of buying versus renting a home. This is because home prices are set by the volume of homebuyers versus home-sellers. If would-be homebuyers decide to rent rather than to buy – because renting gets them ‘more house’ – then it will drag down home prices. Here’s the concern. For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. Put another way, whatever your monthly housing budget, you can now rent a home worth twice as much as you can buy (Chart I-3 and Chart I-4). Chart I-3It Now Costs Twice As Much To Buy Than To Rent A UK Home! Chart I-4It Now Costs Twice As Much To Buy Than To Rent A US Home! The Universal Theory Of House Prices Buying and renting a home are not the same thing, so the head-to-head comparison between the mortgage rate and rental yield is a simplification. Buying and renting are similar in that they both provide you with somewhere to live, a roof over your head or, in economic jargon, the consumption service called ‘shelter’. But there are two big differences. First, unlike renting, buying a home also provides you with an investment whose value you expect to increase in the long run. Second, unlike renting, buying a home incurs you the costs of maintaining it and keeping it up-to-date. Studies show that the annual cost averages around 2 percent of the value of the home.1 So, versus renting, buying a home provides you with an expected capital appreciation, but incurs you a ‘depreciation’ cost of around 2 percent a year. Which results in the following equilibrium between buying and renting: Mortgage rate = Rental yield + Expected house price appreciation - 2 But we can simplify this. In the long run, the price of any asset must trend in line with its income stream. Therefore, expected house price appreciation equates to expected rental growth. Also, rents move in lockstep with wages (Chart I-5). Understandably so, because rents must be paid from wages. And wage growth itself just equals consumer price inflation plus productivity growth, which averages around 1 percent (Chart I-6). Pulling all of this together, the equilibrium simplifies to: Chart I-5Rents Track Wages Chart I-6Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Mortgage rate = Rental yield + Expected consumer price inflation - 1 So, here’s our first conclusion. Assuming central banks achieve their long-term inflation target of 2 percent, the equilibrium becomes: Mortgage rate = Rental yield + 1 Under this assumption, to justify the current UK rental yield of 3 percent, the UK mortgage rate must plunge to 4 percent. But given that the government has just triggered an incipient balance of payments and currency crisis, the mortgage rate is likely to head even higher. In which case the rental yield must rise to at least 4 percent. Meaning either house prices falling 25 percent, or rents rising 33 percent. Meanwhile, to justify the current US rental yield of 3.7 percent, the US mortgage rate must plunge to 4.7 percent. Alternatively, to justify the current mortgage rate of 7 percent, the rental yield must surge to 6 percent. Meaning either house prices crashing 40 percent, or rents surging 60 percent. More likely though, all variables will correct. The equilibrium between buying and renting will be re-established by some combination of lower mortgage rates, lower house prices, and higher rents. The Housing Investment Cycle Is Turning Down The relationship between buying and renting a home raises an obvious counterargument. What if central banks cannot achieve their goal of price stability? In this case, expected inflation in the equilibrium would be considerably higher than 2 percent. This would justify a much higher mortgage rate for a given rental yield. Put differently, it would justify rental yields to stay structurally low (house prices to stay structurally high), even if mortgage rates marched higher. In an inflationary environment, houses would become the perfect foils against inflation. In an inflationary environment, houses would become the perfect foils against inflation because expected rental growth would track inflation – allowing rental yields to stay depressed versus much higher mortgage rates. This is precisely what happened in the 1970s. When the US mortgage rate peaked at 18 percent in 1981, the US rental yield barely got above 6 percent (Chart I-7). Chart I-7In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... If the market fears another such inflationary episode, would it make the housing market a good investment? In the near term, the answer is still no, for two reasons. First, even if rental yields do not track mortgage rates higher point for point, the yields do tend to move in the same direction – especially when mortgage rates surge as they did in the 1970s (Chart I-8). Some of this increase in rental yields might come from higher rents, but some of it might also come from lower house prices. Chart I-8...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together Second, based on the US, it is a bad time in the housing investment cycle. Theoretically and empirically, residential fixed investment tracks the number of households in the economy. But there are perpetual cycles of underinvestment and overinvestment – the most spectacular being the overinvestment boom that preceded the 2007-08 housing crisis. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Therefore, contrary to the popular perception, there is not an undersupply of homes, but a marked oversupply relative to the number of households. (Chart I-9). This is important because, as the cycle turns down now – as it did in 1973, 1979, 1990, and 2007 – the preceding overinvestment always weighs down housing valuations (Chart I-10). Chart I-9The US Housing Investment Cycle Has Moved Into Overinvestment Chart I-10A Housing Investment Downcycle Always Weighs On Housing Valuations The Investment Conclusions Let’s sum up. If the market believes that economies will return to price stability, then to reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. If the market believes that economies will not return to price stability, then house prices are still near-term vulnerable to rising mortgage rates – especially in the US, as a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation – even if the markets do not believe it now. This reiterates our ‘2022-23 = 1981-82’ template for the markets, as recently explained in Markets Still Echoing 1981-82, So Here’s What Happens Next. In summary, a coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. Analysing The Pound’s Crash Through A Fractal Lens Finally, the incipient balance of payments and sterling crisis triggered by the UK government’s unfunded tax cuts has collapsed the 65-day fractal structure of the pound (Chart I-11). This would be justified if the Bank of England does not lean against the fiscal laxness with a compensating tighter monetary policy. But if, as we expect, monetary policy adjusts as a short-term counterbalance, then sterling will experience a temporary, but playable, countertrend bounce. Chart I-11The Pound Usually Turns When Its Fractal Structure Has Collapsed On this assumption, a recommended tactical trade, with a maximum holding period of 65 days, is to go long GBP/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Chart 1Hungarian Bonds Are Oversold Chart 2Copper's Tactical Rebound Maybe Over Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started Is Fragile Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 11The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Fragile Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The Rate of Return on Everything, 1870–2015 (frbsf.org) Fractal Trading System Fractal Trades 6-12 Month Recommendations 6-12 MONTH RECOMMENDATIONS EXPIRE AFTER 15 MONTHS, IF NOT CLOSED EARLIER. Structural Recommendations Closed Fractal Trades 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  

Executive Summary At the margin, the European Union’s proposed €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power will blunt the message markets are sending to consumers to conserve energy, by distributing this windfall to households to offset higher energy costs. A “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of “fossil-fuel tax” – will reduce capex at a time when it is needed to expand supply. These measures – the direct fallout of the EU’s failed Russia-engagement policy – will compound policy uncertainty in energy markets, which also will discourage investment in new supply. Efforts to contain energy prices of households and firms in the UK will be borne by taxpayers, who will be left with a higher debt load in the wake of the government’s programs to limit energy costs, and higher taxes to service the debt. EU Still At Risk To Russia Gas Cutoff Bottom Line: The EU and UK governments are inserting themselves deeper into energy markets, which will distort fundamentals and prices, leaving once-functioning markets “unfit for purpose.” This likely will reduce headline inflation beginning in 3Q22 by suppressing energy prices, and will discourage conservation and capex. Energy markets will remain tight as a result. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We will re-open these positions at tonight’s close with 10% stop-losses. Feature The EU is attempting to address decades of failed policy – primarily its Ostpolitik change-through-trade initiative vis-à-vis Russia – in a matter of months.1 This policy was brought to a crashing halt earlier this year by Russia’s invasion of Ukraine, which led to an economic war pitting the EU and its NATO allies against Russia. This conflict is playing out most visibly in energy markets. For investors, the most pressing issue in the short term center around the trajectory of energy prices – primarily natural gas, which, unexpectedly, has become the most important commodity in the world: It sets the marginal cost of power in the EU; forces dislocations in oil and coal markets globally via fuel substitution, and drives energy and food inflation around the world higher by increasing space-heating fuel costs and fertilizer costs. These effects are unlikely to disappear quickly, especially in the wake of deeper government involvement in these markets. The EU is dealing with its energy crisis by imposing taxes on power generators and hydrocarbons producers. It is proposing a €140 billion “windfall profits” tax on electricity providers not using natural gas to generate power, and is advancing a “solidarity contribution” from oil, gas and coal producers – an Orwellian rendering of a “fossil-fuel tax. Lastly, the EU will mandate energy rationing to stretch natural gas supplies over the summer and winter heating season. The tax hikes under consideration will reduce capex at a time when it is needed to expand supply. Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy The UK is taking a different route v. the EU, by having the government absorb the cost of stabilizing energy prices for households and firms directly on its balance sheet. Beginning 1 October, annual energy bills – electricity and gas – will be limited to £2,500. The government is ready to provide support for firms facing higher energy costs out of a £150 billion package that still lacks formal approval via legislation to be dispensed. This obviously has businesses concerned.2 Over the medium to long term, this economic war will realign global energy trade – bolstering the US as the world’s largest energy exporter, and cementing the alliance of China-Russia energy trade. Whether this ultimately evolves into a Cold War standoff remains an open question. EU Policy Failures And The Power Grid’s Limitations Chart 1Russia Plugged The Gap In EU Energy Supply In addition to its failed Russia policy, the EU’s aggressive support of renewable energy disincentivized domestic fossil fuel production and forced an increased reliance on imports – with a heavy weighting toward Russian hydrocarbons – instead. Once Russia stopped playing the role of primary energy supplier to the EU, the bloc’s energy insecurity became obvious (Chart 1). The EU’s current power-pricing system is forcing households and industries to bear the brunt of energy insecurity and high natgas prices resulting from poor energy policy design.3 And it forces the government to tax energy suppliers – with “windfall profits” taxes ostensibly meant to capture economic rents, as officials are wont to describe the taxes – to fund consumer-support programs. While REPowerEU aims to alleviate the bloc’s energy insecurity by importing non-Russian LNG and increasing renewable energy’s share in the energy mix, both alternatives face bottlenecks, which could delay their implementation. This could keep energy markets in the EU tight over the medium term, until additional LNG capacity comes online in the US and elsewhere. Renewable electricity is not as reliable as electricity generated by fossil fuels on the current power grid, which needs to be constantly balanced to avoid cascading failure. This means power consumed must equal power supplied on a near-instantaneous basis to avoid grid failure. However, given its reliance on variable weather conditions, renewable energy by itself cannot keep the grid balanced, primarily due to the lack of utility-scale storage for renewable power. Battery-storage technology and green-hydrogen energy can be used in conjunction with other renewables to balance the power grid, but they still are nascent technologies and not yet scalable to the point where they can replace hydrocarbon energy sources. Furthermore, the continued addition of small-scale renewables-based power generation located further away from demand centers – cities and industrial complexes – will continue to increase the complexity and scale of the power grid.4 Realizing the importance of incumbent power sources and the infrastructure requirements to diversify away from Russian fuels, the EU labelled investments in natural gas and nuclear power as green investments in July.5 Of the two energy sources, natural gas will likely play a larger role in ensuring the bloc’s energy security over the next 3-5 years, given the polarized views on nuclear power.6 In its most recent attempt to stabilize power prices, the EU plans to redirect “inframarginal” power producers’ windfall profits to households and businesses, provided those producers do not generate electricity using natgas. The Commission did not suggest capping Russian natgas prices since that could be divisive among EU member states, and could further jeopardize the bloc’s energy security. The redistribution of the windfall profits taxes is coupled with calls for mandatory electricity demand reductions in member states. We are unsure of the net effect of these directives on physical power and natural gas balances. However, government interference will feed into the policy uncertainty surrounding electricity and natural gas markets. EU Storage Continues To Build Against all odds, the EU has been aggressively building gas in storage (Chart 2), as demand from Asia has been low during the summer months (Chart 3). This has allowed high Dutch Title Transfer Facility (TTF) prices – the European natgas benchmark – to lure US LNG exports away from Asia (Chart 4). According to Refinitiv data, US exports of LNG to Europe increased 74% y/y to a total of over 1,370 Bcf for the first half of 2022. Chart 2Europe Has Been Aggressively Building Gas Storage Chart 3US LNG Exports To Asia Dropped In H1 2022 Chart 4High TTF Prices Attract US LNG Since Russian gas flows to Asian states have not been completely cut off, this will reduce ex-EU demand for US LNG, providing much needed breathing room for international LNG markets. However, as the pre-winter inventory-injection period in Asia continues, there is an increasing likelihood the spread between Asian and European gas prices narrows. This could incentivize US producers to export more fuel to Asia, slowing the EU’s build-up of gas storage. US plans to increase LNG export capacity will alleviate current tightness in international gas markets over the medium term, as new export facilities are expected to begin operations by 2024, and be fully online by 2025 (Chart 5). Until US LNG exports increase, global natgas markets will continue to remain tight and prices will be volatile. Chart 5US LNG Export Capacity Projected To Rise Russia’s Asian Gas Pivot Since the energy crisis began, China has accelerated the rate at which it imports discounted Russian LNG.7 Russia is aiming to increase gas exports to China to replace the sales lost to the EU following its invasion of Ukraine. Russia recently signed a deal with China to increase gas flows by an additional 353 Bcf per year, with both states agreeing to settle this trade in yuan and rouble to circumvent Western currencies, primarily the USD. Additionally, the Power of Siberia pipeline is expected to reach peak transmission capacity of ~ 1,340 Bcf per year by 2025. Chart 6China Will Not Want All Eggs In One Basket Adding to the China-Russia gas trade is the planned Power of Siberia 2 pipeline, which will have an annual expected capacity of 1,765 Bcf. This will move gas to China from western Siberia via Mongolia, and is expected to come into service by 2030; construction is scheduled to begin in 2024. This will redirect gas once bound toward the EU to China. Russia’s ability to develop and construct the required infrastructure to pivot gas exports to China and the rest of Asia will be hindered by Western sanctions, as international private companies walk away from Russian projects and international investment in that state decline. This is a deeper consequence of the sanctions imposed by the US and its allies, as it denies Russia the capital, technology and expertise needed to fully develop its resource base. On China’s side, even if both Power of Siberia pipelines are developed to operate at full capacity, the world’s largest natgas importer may be wary of becoming overly reliant on Russia for a significant proportion of its gas (and oil) imports. China has developed a diversified network of natgas suppliers, which, as the experience of the EU demonstrates, is the best way to avoid energy-supply shocks (Chart 6). Investment Implications We expect natural gas price volatility to remain elevated over the next 2-3 years. EU governments’ interference with the natgas and power markets' structure and pricing mechanisms – be it via natgas price caps or skimming gas suppliers’ profits – will distort price signals, detaching them from fundamental gas balances. This will perpetuate the energy crisis currently plaguing the EU, by encouraging over-consumption of gas and reducing capex via taxes and levies on profitable companies operating below the market’s marginal cost curve. As a result of the dislocations caused by Russia’s invasion of Ukraine, dislocations in natural gas trade flows will continue, forcing markets to find work-arounds to replace lost Russian pipeline exports in the short-to-medium term. The EU will become more reliant on US LNG supplies, and will – over the next 2-3 years – have to outbid Asian states for supplies. Trade re-routing will take time and likely will lead to sporadic, localized shortages in the interim. The US is the largest exporter of LNG at present, but, by next year, it’s export capacity will max out. It will only start to increase from 2024, reaching full capacity by 2025. While higher export capacity from the world’s largest LNG supplier will help alleviate tight markets, in the interim, global gas prices, led by the TTF will remain elevated and volatile. The EU still receives ~ 80mm cm /d of pipeline gas from Russia, or ~ 7.4% of 2021 total gas consumption on an annual basis (Chart 7). A complete shut-off of Russian gas flows to the EU means the bloc would face even more difficulty refilling storage in time for next winter. This would keep the energy- and food-driven components of inflation high, and constrain aggregate demand in the EU generally. Chart 7EU Still At Risk To Russia Gas Cutoff We continue to expect global natural gas markets to remain tight this year and next. We also expect natural gas prices to remain extremely volatile – particularly in winter (November – March), when weather will dictate the evolution of price levels. We were stopped out of our long the COMT ETF with a loss of 5.4% and our XOP ETF with a gain of 24.6%. We remain bullish commodities generally and oil in particular, and will re-open these positions at tonight’s close with 10% stop-losses.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate and jet-fuel stocks recovered slightly in the week ended 9 September 2022, rising by 4.7mm barrels to just over 155mm barrels, according to the US EIA. Distillate inventories – mostly diesel fuel and heating oil – stood at 116mm barrels, down 12% y/y. At 39.2mm barrels, jet fuel stocks are 7% below year-earlier levels. Refiners are pushing units to build distillates going into winter, in order to meet gas-to-oil switching demand in Europe and the US. Distillate inventories have been under pressure for the better part of the summer on strong demand. This is mostly driven by overseas demand. Distillate demand fell by 492k b/d last week, which helped domestic inventories recover. Year-on-year distillate demand was down 1.6% in the US. Ultra-low sulfur diesel prices delivered to the NY Harbor per NYMEX futures specification are up 50% since the start of the year (Chart 8). Base Metals: Bullish On Monday Chile’s government launched a plan to boost foreign investments, which includes providing copper miners with a 5-year break from the ad-valorem tax proposed in a new mining royalty. The plan however does not provide relief from the tax on operating profits, which are also part of the royalty. According to Fitch, the originally planned mining royalty would have significantly depleted copper miners’ profits, disproportionately impacting smaller operators, which cannot avail themselves of the benefits of economies of scale. In a sign that higher taxes spooked bigger players as well, in mid-July, BHP stated that it would reconsider investment plans in Chile if the state proceeded with the mining royalty in its original format. Ags/Softs: Neutral In its September WASDE, the USDA adjusted its supply and demand estimates for soybeans, and made substantial changes to new-crop 2022/23 US production estimates. This reduced acreage and yields by 2.7% from the previous August 2022 forecast. Ukraine’s soybean production was increased in the USDA's estimate. The USDA's soybean projections also include lower ending stocks, which are reduced from 245 million bushels to 200 million bushels. This is 11% below than 2021 levels for beans. The USDA's 2021/22 average price for soybeans remains at $14.35/bu, unchanged from last month but $1.05/bu above the 2021/22 average price (Chart 9). Chart 8NY Harbor ULSD Price Going Down Chart 9Soybean Prices Going Down   Footnotes 1 For a discussion of the EU’s past policy mistakes which laid the foundation for current crisis, please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022. It is available at ces.bcaresearch.com. 2 Please see UK business warned of delay to state energy support, published by ft.com on September 13, 2022. 3 The current EU power pricing system is set up so that the most expensive power generator – currently plants using natgas – set the price for the entire electricity market. This system was put in place to incentivize renewably  generated power, however, the EU does not have the required infrastructure and technology to be reliant solely on green electricity. 4 For a more detailed discussion on power grid stability, and how renewables will affect it, please ENTSO-E’s position paper on Stability Management in Power Electronics Dominated Systems: A Prerequisite to the Success of the Energy Transition. According to estimates by WindEurope and Hitachi Energy, Europe will need to double annual investments in the power grid to 80 billion euros over the next 30 years to prepare the power grid for renewables. 5 For our most recent discussion on the infrastructure requirements of pivoting away from Russian piped gas, please see Natgas Markets: The Eye Of The Storm, which we published on June 9, 2022. It is available at ces.bcaresearch.com.  6 In 2021, nuclear power constituted majority of France’s energy mix at 36% and had nearly the lowest share for Germany at 5%. In response to the current energy crisis, Germany has opted to restart coal power plants and only keep nuclear plants on standby, signaling that the EU’s largest energy consumer would prefer to use coal despite its carbon emissions target. 7 According to Bloomberg, China signed a tender to receive LNG from Russia’s Sakhalin-2 project through December at nearly half the cost of the spot gas rates at the time. Investment Views and Themes  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG THE COMT ETF WITH A LOSS OF 5.4% AND OUR XOP ETF WITH A GAIN OF 24.6%. WE WILL RE-OPEN THESE POSITIONS AT TONIGHT’S CLOSE WITH 10% STOP-LOSSES. Strategic Recommendations Trades Closed in 2022

Special Report

Executive Summary Central banks are aggressively tightening policy around the world. Their ability to rein in inflation without causing a recession depends upon the level of the real neutral rates. Australia, Canada, New Zealand, and Sweden have elevated r-stars, but the picture changes drastically when their large debt loads are factored in. While real policy rates remain below r-star across DM economies for now, a more rapid decline in supply-driven inflation would correct this situation. Consequently, a global recession does not constitute our base case for the next six months, although it is a growing threat. The ECB is front-loading interest rate increases while it can, but the destination of travel is not changing significantly. Global R-Star Bottom Line: The global r-star varies greatly around the world and debt sustainability concerns weigh on the real neutral rates of Australia, Canada, New Zealand, and Sweden. The US economy remains best capable of handling higher interest rates.   Chart 1Rising Global Inflation Inflation around G10 economies has been very strong and much more durable than originally hoped. As a result, inflation now averages 7.1% on a headline CPI basis and 4.6% based on core CPI across among G10 economies (Chart 1). Central banks are tightening policy aggressively to prevent this elevated inflation from becoming entrenched. Essentially, they are aiming to avert the emergence of the kind of inflationary mentality that prevailed in the 1970s, which caused stubborn inflation during that decade. This exercise is fraught with difficulty. The objective is to achieve a policy setting that is slightly above the neutral rate of interest, but not too much so. On the one hand, keeping policy too accommodative will increase the chances that an inflationary mentality will emerge; on the other hand, if policy is tightened too much, a recession will become unavoidable and deflationary risks will escalate. A sense of where the neutral rate for major economies lies is therefore necessary to draw that line in the sand. To do so, we estimate the real neutral rate of interest for major DM economies using the methodology we introduced seven weeks ago, when we evaluated the neutral rates for the major Eurozone economies. This exercise shows that, at the current level of interest rates and inflation, policy among major economies remains accommodative. However, if inflation decelerates sharply in the coming months in response to declining global supply constraints and lower commodity prices, the recent increase in policy rates will have already gone a long way to normalizing monetary policy around the world. A Simple Approach The methodology we use is based on the approach developed by Holston, Laubach, and Williams (HLW)  to estimate the neutral real interest rate – or “r-star.” Specifically, we run regressions between the real interest rates in the US, Japan, the UK, New Zealand, Canada, Australia, Sweden, and Switzerland versus trend GDP growth and current account balances, which approximate the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average of core CPI.1  Table 1Unadjusted R-Stars The results are shown in Table 1. New Zealand, Australia, and Canada have the highest real-neutral rate of the major economies. They have had stronger growth over the past 20 years because of their rapid population growth caused by high immigration rates. Moreover, their commodity-based economies and their booming construction sectors pushed up investment rates, which requires high interest rates to attract sufficient savings to finance. Sweden and the US follow. These two economies have lower population growth rates than the commodity producers; nonetheless, they outperform Japan and the other European nations in the survey on that dimension. Moreover, they fare comparatively well in terms of productivity growth, which implies that their trend growth – a key driver of the neutral rate – is also higher than that of the UK, Japan, Switzerland, or the Euro Area. The US’s r-star shows up as being slightly below what would be expected based on its potential GDP growth. This surprising outcome most likely reflects the role of the dollar in global FX reserves and its standing at the core of the global financial system. These two characteristics of the greenback create an important demand for dollar-denominated assets that is dissociated from US domestic economic fundamentals. This additional demand biases downward the US real neutral rate and suggests that weak trend growth abroad and global excess savings remain important forces for US financial markets. Chart 2Japan's Dissociated Real Rates Japan displays a surprisingly elevated real neutral rate of 0.1%. This result reflects the limitation of the approach. Japanese interest rates have been at zero since the late 1990s and real rates have been negatively correlated with inflation because of this nominal rigidity (Chart 2). However, while Japanese inflation has averaged a paltry 0.2% since 1997, it has nonetheless fluctuated with commodity prices and global economic activity. As a result, real rates have been essentially dissociated from Japanese domestic drivers. Hence, an empirical approach based on the evolution of domestic economic variables yields poor results for Japan. Instead, the lack of inflation when public debt has increased by 200% of GDP over the past 32 years and Japan’s large net international investment position imply that its r-star is inferior to that of the other countries in the sample, and thus should lie below -1%. For the Eurozone, we use the average result of our July study, which estimated the neutral rates of Germany, France, Italy, and Spain independently. Germany flatters this estimate since its real neutral rate stands near 0%. An average, excluding Germany, would be closer to -0.5%, or well below the US r-star. Meanwhile, the Swiss r-star is depressed by both a low population growth and the Swiss exceptional savings generation, as highlighted by its current account surplus that has averaged 8% of GDP over the past 20 years. Finally, the UK’s r-star stands at the bottom of the pack. The UK’s productivity growth has been very poor over the past ten years, averaging 0.7% per annum. This points to a weak potential GDP for that economy. Moreover, the hurdles to UK growth have only increased in recent years with the implementation of Brexit, which is hurting the availability of labor in the country, while putting the UK at an even greater disadvantage in European markets, its largest export destination. What About Debt? This approach to estimating r-star ignores a key dimension: debt sustainability. If we factor in this crucial variable, the level of interest rates causing economic activity to decelerate changes drastically for many countries. Chart 3Massive Real Estates Bubbles Since 2000, real estate prices have surged by 280%, 220%, 170%, and 200% in New Zealand, Canada, Australia, and Sweden, respectively. These gains dwarf the house price appreciation observed in the US, the UK, Japan, or Germany (Chart 3, top panel). This outperformance of house prices is particularly problematic because it does not reflect more rapid underlying cash-flow growth from the assets. Instead, the main driver of the stronger house prices in New Zealand, Canada, Australia, and Sweden has been the explosion of their price-to-rent and price-to-income ratios (Chart 3, bottom two panels). Rising real estate prices boosted economic activity relative to the underlying trend GDP of these countries. As a result, the long-term growth numbers of these four nations potentially overstate their underlying rate of growth. Even more importantly, real estate prices and activity are extremely sensitive to interest rates. Therefore, the risk of bursting bubbles in New Zealand, Canada, Australia, and Sweden limits how high interest rates may rise there without causing growth to plunge and deflationary spirals to emerge. Chart 4Rapidly Rising Debt Loads The accumulation of debt in these four countries accentuates the threats to growth created by real estate activity. The private-sector debt of New Zealand, Canada, Australia, and Sweden has risen much more quickly than has been the case in Germany and the US (Chart 4). Ultimately, these debt burdens create major headwinds against higher interest rates and suggest that the effective r-star of these nations lies well below the estimates constructed using only trend growth and the savings/investment balance. Table 2Drastic Changes Once Debt Is Accounted For To account for the private-sector leverage, we estimated new debt-adjusted r-stars. The impact of high debt loads on r-star estimates is evident in Table 2. The average real neutral rate of New Zealand, Australia, and Canada drops from 1.9% to -1.9%. In fact, Australia and Canada would sport the lowest r-star estimates of the nations under study. Sweden’s neutral rate also experienced a big decline from 0.6% to 0.2%. The US r-star estimate is also lowered by the addition of debt metrics in its equation, declining from 0.2% to -0.4%. The Eurozone average r-star experiences a significant decrease as well, driven mostly by Spain and France. The Swiss economy also sports a large private debt load, and its r-star is therefore curtailed from -0.75% to -1.3%. Finally, Japan’s r-star estimate barely changes, which confirms that the approach does not work well for that country. The greatest drawback of the method is that it is backward-looking. The main force that has brought down the global r-star over the past 20 years is the collapse in trend growth among most advanced economies (Chart 5). Consequently, neutral rates could improve from their current low levels if trend growth were to pick up in the coming years. On the positive side, the current age of the capital stock in both Europe and the US is extremely advanced (Chart 6), which suggests that a capex upturn is likely. Such an upturn would boost productivity and lift the r-star among most major economies. On the negative side, the growth of human capital is deteriorating as educational attainment stalls among most DM nations. The decline in the growth rate of human capital is a large threat to productivity over the coming decades. These problems are magnified in the Eurozone, as its high degree of economic fragmentation, lack of common fiscal policy, and higher regulatory burden create further handicaps to trend growth. Chart 5R-star And Global Growth Chart 6A Capex Revival? Bottom Line: Estimating the real neutral rates for the global economy often relies on trend growth and the savings/investment balance. However, such an approach often misses the vulnerability to higher interest rates created by high private-sector indebtedness. If this constraint is considered, the high r-star recorded in countries like New Zealand, Australia, or Canada is reduced dramatically. The US r-star also declines but significantly less so. As we already showed seven weeks ago, the same phenomenon is also visible in the Eurozone, albeit driven by France and Spain, not Germany or Italy. Investment Implications There are three main conclusions from the analysis above. First, the risk of a financial accident in commodity-producing economies is growing increasingly large. On the one hand, economies like New Zealand, Australia, and Canada are buoyed by the recent surge in commodity prices, with agricultural prices up 90% since their 2020 lows, metal prices up 68%, and energy prices up 340% since April 2020. On the other hand, the inflationary pressures created by robust commodity sectors invite the RBNZ, the RBA, and the BoC to lift interest rates quickly, which is hurting massively indebted private sectors. Already, in response to the 275bps and 300bps of hikes implemented by the RBNZ and the BoC, house prices in New Zealand have begun to buckle, down 12% and since their more recent peaks, and they are expected to plunge by as much as 25% in Canada by the end of next year. Chart 7NZD And CAD At A Disadvantage This suggests that non-commodity equities in Canada, Australia, and New Zealand, especially financials, could experience significant periods of underperformance, both against their domestic equity benchmark and global market averages. Additionally, while the NZD, AUD, and CAD all benefit from improving terms of trades, the potential for domestic weakness is such that these currencies are likely to lag their historical sensitivity to commodity price fluctuations. In fact, according to BCA’s foreign exchange strategist, the New Zealand and Canadian dollars are among the most expensive currencies in the G10 (Chart 7), and thus, it is likely to underperform other pro-cyclical currencies once the USD bull market reverses. Second, the neutral rate in the US has risen by 200bps relative to the rest of the world over the past seven years. The US economy has undergone a long deleveraging period in the wake of the GFC, which means that its private-debt-to-GDP ratio has declined relative to other advanced economies. Consequently, the vulnerability of the US economy to higher interest rates has decreased, even if relative US trend growth has not improved meaningfully. The market implications of this pickup in the neutral rate are manifold. To begin with, it allows US rates to rise further relative to other DM economies. BCA’s Global Fixed Income Strategy team continues to underweight US Treasurys in global fixed-income portfolios, especially relative to German Bunds (Chart 8). As a corollary, it also means that US financials are likely to continue to outperform their foreign peers, especially Canadian and Australian ones which will bear the brunt of the negative consequences of their debt bubbles. The increase in the US r-star relative to the rest of the world has been a key contributor to the dollar rally. It helps explain why the recent dollar strength has not hurt relative profit growth (Chart 9). However, the dollar is trading at a 32% premium to its purchasing power parity, or the same overvaluation as in 1985 and 2001. Thus, with the worsening US balance of payment picture, the US dollar is vulnerable to an eventual improvement in global growth next year. Chart 8US Rate Differentials Have Upside Chart 9The US Fares Better Chart 10Easy Or Not? Finally, despite the recent increase in rates, the high level of inflation recorded around the world implies that real policy rates are still well below r-star for major global economies, whether one uses actual inflation or the smooth formulation recommended by the HLW paper (Chart 10). This suggests that a recession is unlikely, especially in the US. The recession threat is higher in Europe but has little to do with policy. It is mostly a consequence of the massive terms of trade shock caused by the sudden jump in European energy prices in the wake of the Ukrainian war. However, because policy remains accommodative even in Europe, it follows that the Eurozone economy will rebound quickly once the worst of the energy shock is over next spring. Some humility is required. It is hard to gauge how much of the inflation surge over the past 18 months reflects supply factors. If inflation suddenly becomes much weaker because the easing in supply constraints has a greater-than-anticipated impact on inflation, real interest rates would jump rapidly around the world. In this scenario, policy rates could rise quickly and overtake r-star. This would mean that the disinflation impulse could rapidly morph into an outright deflationary environment, which implies that the odds of a deflationary bust like the one experienced in 1921 is greater than the market currently prices in.  Bottom Line: The debt-fueled real estate bubbles in the dollar-bloc economies suggests that they are at a greater risk of a financial accident than the US or the Eurozone. As a result, their financial sector looks vulnerable. Meanwhile, the higher US r-star compared to that of the rest of the world will continue to support higher yields in the US rather than in Europe or Japan. This phenomenon has been hugely positive for the US dollar, but it has likely run its course. Finally, global real interest rates remain below r-star estimates. Hence, the current slowdown is likely to prove to be a mid-cycle slowdown and Europe will rebound quickly from a potential recession caused by the recent surge in its energy prices. The ECB Joins The 75bps Club Last week, the ECB increased interest rates by 75bps, which brought its deposit rate to 0.75%. Interestingly, the euro did not rally much in response to this policy decision, even though it has not been fully discounted by the market. At first glance, the lack of responsiveness from European assets seems strange, especially since the vote for a 75bps rate hike was unanimous. The ECB is taking advantage of strong economic numbers to push up rates rapidly. The Eurozone Q2 GDP growth was robust at 0.6%, while the unemployment rate hit an all-time low of 6.6%. Meanwhile, inflation continues to beat consensus forecasts, with Eurozone core CPI and headline CPI standing at 4.3% and 9.1%, respectively in August. Chart 11Big ECB Revisions The market believes that more rapid interest rate hikes now will not translate into a much higher terminal rate, with the expected rates for June 2023 moving from 2.2% on September 7th to 2.4% after last Thursday’s decision. The ECB may have increased its inflation forecasts for the whole horizon, but it has also brought down GDP forecasts to 0.9% and 1.9% in 2023 and 2024, respectively (Chart 11). Moreover, ECB President Christine Lagarde went out of her way to telegraph to investors that the number of upcoming hikes was finite. The jumbo hike does not spell the start of a euro rally—for now. First, the lack of major change in the ECB’s terminal deposit rate is more important than the more rapid pace of hikes for the remainder of 2022. Second, the Fed is also lifting rates faster than investors expected ahead of the Jackson Hole meeting three weeks ago. Third, the euro remains vulnerable to any flare-ups in the energy market. True, natural gas and electricity prices have recently fallen, but the situation in Ukraine continues to be highly fluid, which suggests that volatility will linger in the energy market over the coming weeks.   Despite the near-term hurdles, the euro’s medium-term outlook is brightening. We are gaining confidence in our thesis that energy prices will peak once natural gas inventories have reached approximately 90% by November. Additionally, the support of the Governing Council’s doves for a 75bps hike suggests that they received something in exchange for their votes. In our view, this “something” is an activation of the Transmission Protection Instrument (TPI) before year-end. The TPI activation will allow for a normalization of the risk premia in the Italian debt market and will support the ECB’s ability to increase interest rates further down the road, despite the much lower r-star in Italy, Spain, and France than in Germany (Table 3). Table 3The Eurozone’s Different R-Stars Will Force The TPI’s Activation Bottom Line: The ECB may have delivered a jumbo hike last week, but its market impact was muted. Investors understand full well that the ECB is taking advantage of the recent bout of robust economic activity to front-load interest rate increases ahead of a likely economic contraction in Q4 2022 and Q1 2023. As a result, the terminal rate estimates have scarcely moved. Ultimately, we expect the ECB deposit rate to settle between 1.5% and 2% in the summer of 2023. While the move may not provide much of a boost to the euro in the near term, conditions are falling into place for a euro rally later this year.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1     For the US, we opted for core PCE, since it is the benchmark inflation measure the Federal Reserve uses.