Inflation

Dear Client, We are sending you our Strategy Outlook today where we outline our thoughts on the global economy and the direction of financial markets for 2022 and beyond. Next week, please join me for a webcast on Friday, December 10th at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) to discuss the outlook. Also, we published a report this week transcribing our annual conversation with Mr. X, a long-standing BCA client. Please join my fellow BCA strategists and me on Tuesday, December 7th for a follow-up discussion hosted by my colleague, Jonathan LaBerge. Finally, you will receive a Special Report prepared by our Global Asset Allocation service on Monday, December 13th. Similarly to previous years, Garry Evans and his team have prepared a list of books and articles to read over the holiday period. This year they recommend reading materials on key themes of the moment, such as climate change, cryptocurrencies, supply-chain disruption, and gene technology. Included in this report are my team’s recommendations on what to read to understand the underlying causes of inflation. Best regards, Peter Berezin, Chief Global Strategist   Highlights Macroeconomic Outlook: Despite the risks posed by the Omicron variant, global growth should remain above trend in 2022. Inflation will temporarily dip next year as goods prices come off the boil. However, the structural trend for inflation is to the upside, especially in the US. Equities: Remain overweight stocks in 2022, favoring cyclicals, small caps, value stocks, and non-US equities. Look to turn more defensive in mid-2023 in advance of a stagflationary recession in 2024 or 2025. Fixed income: Maintain below-average interest rate duration exposure. The US 10-year Treasury yield will rise to 2%-to-2.25% by the end of 2022. Underweight the US, UK, Canada, and New Zealand in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds next year. Favor HY over IG. Spreads will widen again in 2023. Currencies: As a momentum currency, the US dollar could strengthen some more over the next month or two. Over a 12-month horizon, however, the trade-weighted dollar will weaken. The Canadian dollar will be the best performing G10 currency next year. Commodities: Oil prices will rise, with Brent crude averaging $80/bbl in 2022. Metals prices will remain resilient thanks to tight supply and Chinese stimulus. We prefer gold over cryptos. I. Macroeconomic Outlook   Running out of Greek Letters Just as the world was looking forward to “life as normal”, a new variant of the virus has surfaced. While little is known about the Omicron variant, preliminary indications suggest that it is more transmissible than Delta. The emergence of the Omicron variant is coming in the midst of yet another Covid wave. The number of new cases has skyrocketed across parts of northern and central Europe, prompting governments to re-introduce stricter social distancing measures (Chart 1). New cases have also been trending higher in many parts of the US and Canada since the start of November. Despite the risks posed by Omicron, there are reasons for hope. BioNTech has said that its vaccine, jointly developed with Pfizer, will provide at least partial immunity against the new strain. At present, 55% of the world’s population has had at least one vaccine shot; 44% is fully vaccinated (Chart 2). China is close to launching its own mRNA vaccine next year, which it intends to administer as a booster shot. In a worst-case scenario, BioNTech has said that it could produce a new version of its vaccine within six weeks, with initial shipments beginning in about three months. New antiviral medications are also set to hit the market. Pfizer claims its newly developed pill cuts the risk of hospitalization by nearly 90% if taken within three days from the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. In addition, it is allowing generic versions to be manufactured in developing countries. The company has indicated that its antiviral pills will be effective in treating the new strain.   Global Growth: Slowing but from a High Level Assuming the vaccines and antiviral drugs are able to keep the new strain at bay, global growth should remain solidly above trend in 2022. Table 1 shows consensus GDP growth projections for the major economies. G7 growth is expected to tick up from 3.6% in 2021Q3 to 4.5% in 2021Q4. Growth is set to cool to 4.1% in 2022Q1, 3.6% in 2022Q2, 2.9% in 2022Q3, 2.3% in 2022Q4, and 2.1% in 2023Q1. Table 1Growth Is Slowing, But From Very High Levels According to the OECD, potential real GDP growth in the G7 is about 1.4% (Chart 3). Thus, while growth in developed economies will slow next year, it is unlikely to return to trend until the second half of 2023. Emerging markets face a more daunting outlook. The Chinese property market is weakening, and the recent collapse of the Turkish lira highlights the structural problems that some EMs face. Nevertheless, the combination of elevated commodity prices, forthcoming Chinese stimulus, and the resumption of the US dollar bear market starting next year should support EM growth. Relative to consensus, we think the risks to growth in both developed and emerging markets are tilted to the upside in 2022. Growth will likely start surprising to the downside in late 2023, however.   The United States: No Shortage of Demand US growth slowed to only 2.1% in the third quarter, reflecting the impact of the Delta variant wave and supply-chain bottlenecks. The semiconductor shortage hit the auto sector especially hard. The decline in vehicle spending alone shaved 2.2 percentage points off Q3 GDP growth. Chart 4Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up The fourth quarter is shaping up to be much stronger. The Bloomberg consensus estimate is for real GDP to expand by 4.9%. The Atlanta Fed’s GDPNow model is even more optimistic. It sees growth hitting 9.7%. The demand for goods will moderate in 2022. As of October, real goods spending was still 10% above its pre-pandemic trendline (Chart 4). In contrast, the demand for services will continue to rebound. While restaurant sales have recovered all their lost ground, spending on movie theaters, amusement parks, and live entertainment in October was still down 46% on a seasonally-adjusted basis compared to January 2020. Hotel spending was down 23%. Spending on public transport was down 25%. Spending on dental services was down 16% (Chart 5).   US households have accumulated $2.3 trillion in excess savings over the course of the pandemic. Some of this money will be spent over the course of 2022 (Chart 6). Increased borrowing should also help. After initially plunging during the pandemic, credit card balances are rising again (Chart 7). Banks are eager to make consumer loans (Chart 8). Chart 6Plenty Of Pent-Up Demand Chart 7Credit Card Spending Is Recovering Following The Pandemic Slump Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 9). In an earlier report, we estimated that the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8Banks Are Easing Credit Standards For Consumer Loans Chart 9A Record Rise In Household Net Worth   Business investment will rebound in 2022, as firms seek to build out capacity, rebuild inventories, and automate more production in the face of growing labor shortages. After moving sideways for the better part of two decades, core capital goods orders have broken out to the upside. Surveys of capex intentions have improved sharply (Chart 10). Nonresidential investment was 6% below trend in Q3 – an even bigger gap than for consumer services spending – so there is plenty of scope for capex to increase. Residential investment should also remain strong in 2022 (Chart 11). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 6-month high in November. Building permits are 7% above pre-pandemic levels. Chart 10Business Investment Should Be Strong In 2022 Chart 11Residential Construction Will Be Well Supported   US Monetary and Fiscal Policy: Baby Steps Towards Tightening Policy is unlikely to curb US aggregate demand by very much next year. While the Federal Reserve will expedite the tapering of asset purchases and begin raising rates next summer, the Fed is unlikely to raise rates significantly until inflation gets out of hand. As we discuss in the Feature section later in this report, the next leg in inflation will be to the downside, even if the long-term trend for inflation is to the upside. The respite from inflation next year will give the Fed some breathing space. A major tightening campaign is unlikely until mid-2023. Reflecting the Fed’s dovish posture, long-term real bond yields hit record low levels in November (Chart 12). Despite giving up some of its gains in recent days, Goldman’s US Financial Conditions Index stands near its easiest level in history (Chart 13). Chart 12US Real Bond Yields Hitting Record Lows Chart 13Easy Financial Conditions In The US US fiscal policy will get tighter next year, but not by very much. In November, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. The emergence of the Omicron strain will facilitate passage of the bill because it will allow the Democrats to add some “indispensable” pandemic relief to the package. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 14). It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 15). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks. Chart 15While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend Chart 16European Banks Have Cleaned Up Their Act Europe: Room to Grow The European economy faces near-term growth pressures. In addition to Covid-related lockdowns, high energy costs will take a bite out of growth. After having dipped in October, natural gas prices have jumped again due to delays in the opening of the Nord Stream 2 pipeline, strong Chinese gas demand, and rising risks of a colder winter due to La Niña. The majority of Germans are in favor of opening the pipeline, suggesting that it will ultimately be approved. This should help reduce gas prices. Meanwhile, the winter will pass and Chinese demand for gas should abate as domestic coal production increases. The combination of increased energy supplies, easing supply-chain bottlenecks, and hopefully some relief on the pandemic front, should all pave the way for better-than-expected growth across the euro area next year. After a decade of housecleaning, European banks are in much better shape (Chart 16). Capex intentions have risen (Chart 17). Consumer confidence is even stronger in the euro area than in the US (Chart 18). Chart 18Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Euro area fiscal policy should remain supportive. Infrastructure spending is set to increase as the Next Generation EU fund begins operations. Germany’s “Traffic Light” coalition will pursue a more expansionary fiscal stance. The IMF expects the euro area to run a cyclically-adjusted primary deficit of 1.2% of GDP between 2022 and 2026, compared to a surplus of 1.2% of GDP between 2014 and 2019. For its part, the ECB will maintain a highly accommodative monetary policy. While net asset purchases under the PEPP will end next March, the ECB is unlikely to raise rates until 2023 at the earliest. In contrast to the US, trimmed-mean inflation has barely risen in the euro area (Chart 19). Moreover, unlike their US counterparts, European firms are reporting few difficulties in finding qualified workers (Chart 20). In fact, euro area wage growth slowed to an all-time low of 1.35% in Q3 (Chart 21). Chart 19Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan   Chart 21Wage Growth Remains Contained Across The Euro Area The UK finds itself somewhere between the US and the euro area. Trimmed-mean inflation is running above euro area levels, but below that of the US. UK labor market data remains very strong, as evidenced by robust employment gains, firm wage growth, and a record number of job vacancies. The PMIs stand at elevated levels, with the new orders component of November’s manufacturing PMI rising to the highest level since June. While worries about the impact of the Omicron variant will likely cause the Bank of England to postpone December’s rate hike, we expect the BoE to begin raising rates in February.   Japan: Short-Term Stimulus Boost A major Covid wave during the summer curbed Japanese growth. Consumer spending rebounded after the government removed the state of emergency on October 1 but could falter again if the Omicron variant spreads. The government has already told airlines to halt reservations for all incoming international flights for at least one month. On the positive side, the economy will benefit from new fiscal measures. Following the election on October 31, the new government led by Prime Minister Fumio Kishida announced a stimulus package worth 5.6% of GDP. As with most Japanese stimulus packages, the true magnitude of fiscal support will be much lower than the headline figure. Nevertheless, the combination of increased cash payments to households, support for small businesses, and subsidies for domestic travel should spur consumption in 2022. The capex recovery in Japan has lagged other major economies. This is partly due to the outsized role of the auto sector in Japan’s industrial base. Motor vehicle shipments fell 37% year-over-year in October, dragging down export growth with it. As automotive chip supplies increase, Japan’s manufacturing sector should gain some momentum. Despite the prospect of stronger growth next year, the Bank of Japan will stand pat. Core inflation remains close to zero, while long-term inflation expectations remain far below the BOJ’s 2% target. We do not expect the BOJ to raise rates until 2024 at the earliest.   China: Crosswinds The Chinese economy faces crosswinds going into 2022. On the one hand, the energy crisis should abate, helping to boost growth. China has reopened 170 coal mines and will probably begin re-importing Australian coal. Chinese coal prices have fallen drastically over the past 6 weeks (Chart 22). Coal accounts for about two-thirds of Chinese electricity generation. Chart 22Coal Prices Are Renormalizing In China Chart 23China's Property Market Has Weakened   The US may also trim tariffs on Chinese goods, as Treasury Secretary Yellen hinted this week. This will help Chinese manufacturers. On the other hand, the property market remains under stress. Housing starts, sales, and land purchases were down 34%, 21%, and 24%, respectively, in October relative to the same period last year. The proportion of households planning to buy a home has plummeted. Loan growth to real estate developers has decelerated to the lowest level on record (Chart 23). Nearly half of their offshore bonds are trading at less than 70 cents on the dollar. The authorities have taken steps to stabilize the property market. They have relaxed restrictions on mortgage lending and land sales, cut mortgage rates in some cities, and have allowed some developers to issue asset backed securities to repay outstanding debt. Most Chinese property is bought “off-plan”. The government does not want angry buyers to be deprived of their property. Thus, the existing stock of planned projects will be built. Chart 24 shows that this is a large number; in past years, developers have started more than twice as many projects as they have completed. The longer-term problem is that China builds too many homes. Like Japan in the early 1990s, China’s working-age population has peaked (Chart 25). According to the UN, it will decline by over 400 million by the end of the century. China simply does not need to construct as many new homes as it once did. Chart 24Chinese Construction: Halfway Done Chart 25Demographic Parallels Between China And Japan Japan was unable to fill the gap that a shrinking property sector left in aggregate demand in the early 1990s. As a result, the economy fell into a deflationary trap. China is likely to have more success. Unlike Japan, which waited too long to pursue large-scale fiscal stimulus, China will be more aggressive. The authorities will raise infrastructure spending next year with a focus on clean energy. They will also boost social spending. A frayed social safety net has forced Chinese households to save more than they would otherwise for precautionary reasons. This has weighed on consumption.  The fact that China is a middle-income country helps. In 1990, Japan’s output-per-worker was nearly 70% of US levels; China’s output-per-worker is still 20% of US levels (Chart 26). If Chinese incomes continue to grow at a reasonably brisk pace, this will make it easier to improve home affordability. It will also allow China to stabilize its debt-to-GDP ratio without a painful deleveraging campaign. II. Feature: The Long-Term Inflation Outlook   Two Steps Up, One Step Down We expect inflation in the US, and to a lesser degree abroad, to follow a “two steps up, one step down” trajectory of higher highs and higher lows. The US is currently near the top of those two steps. Inflation should dip over the next 6-to-9 months as the demand for goods moderates and supply-chain disruptions abate. Chart 27 shows that container shipping costs have started to come down. The number of ships anchored off the ports of Los Angeles and Long Beach is falling. US semiconductor firms are working overtime (Chart 28). Chip production in Japan and Korea is rising swiftly. DRAM chip prices have already started to decline. Chart 27Signs Of Easing Supply Issues On The Rough Seas Chart 28Semiconductor Manufacturers Are Stepping Up Their Game Reflecting the easing of supply-chain bottlenecks, both the “prices paid” and “supplier delivery” components of the manufacturing ISM declined in November.  The respite from inflation will not last long, however. The US labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 29). Wage growth will broaden out over the course of 2022, pushing up service price inflation in the process. Chart 29Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Chart 30Rent Inflation Has Increased Rent inflation will also rise, as the unemployment rate falls further. The Zillow rent index has spiked 14% (Chart 30). Rents account for 8% of the US CPI basket and 4% of the PCE basket.   Biased About Neutral? Investors are assuming that the Fed will step in to extinguish any inflationary fires before they get out of hand. The widely-followed 5-year/5-year forward TIPS breakeven inflation rate has fallen back below the Fed’s comfort zone (Chart 31). Chart 31Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed Chart 32Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate This may be wishful thinking. Back in 2012, when the Fed began publishing its “dots”, it thought the neutral rate of interest was 4.25%. Today, it considers it to be around 2.5% (Chart 32). Market participants broadly agree. Both investors and policymakers have bought into the secular stagnation thesis hook, line, and sinker. If the neutral rate turns out to be higher than widely believed, the Fed could find itself woefully behind the curve. Given the “long and variable” lags between changes in monetary policy and the resulting impact on the economy, inflation is liable to greatly overshoot the Fed’s target.   Structural Forces Turning More Inflationary Meanwhile, the forces that have underpinned low inflation over the past few decades are starting to fray: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 33). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. Baby boomers are leaving the labor force en masse: As a group, baby boomers hold more than half of US household wealth (Chart 34). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Spending that is not matched by output tends to drive up inflation. Chart 33Globalization Plateaued Over a Decade Ago Social stability is in peril: The US homicide rate increased by 27% in 2020, the biggest one-year jump on record. All indications suggest that crime has continued to rise in 2021, coinciding with the ongoing decline in the incarceration rate (Chart 35). Amazingly, the murder rate and inflation are highly correlated (Chart 36). If the government cannot credibly commit to keeping people safe, how can it credibly commit to keeping inflation low? Without trust in government, inflation expectations could quickly become unmoored. Chart 35The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined Chart 36Bouts Of Inflation Tend To Coincide With Rising Crime The temptation to monetize debt will rise: Public-sector debt levels have soared to levels last seen during World War II. If bond yields rise as the Congressional Budget Office expects, debt-servicing costs will triple by the end of the decade (Chart 37). Faced with the prospect of having to divert funds from social programs to pay off bondholders, the government may apply political pressure on the Fed to keep rates low.​​​​​​   A Post-Pandemic Productivity Boom? Might faster productivity growth bail out the economy just like it did following the Second World War? Don’t bet on it. US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects that saw many low-skilled, poorly-paid service workers lose their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. Productivity growth has been extremely weak outside the US (Chart 38). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is worth noting that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. However, the near-term impact of higher capex will be to boost aggregate demand, stoking inflation in the process. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Our golden rule of investing is about as simple as they come: Don’t bet against stocks unless you think that there is a recession around the corner. As Chart 39 shows, recessions and equity bear markets almost always overlap. Chart 40Sentiment Towards Equities Is Already Bearish Equity corrections can occur outside of recessionary periods. In fact, we are experiencing such a correction right now. Yet, with the percentage of bearish investors reaching the highest level in over 12 months in this week’s AAII survey, chances are that the correction will not last much longer (Chart 40). A sustained decline in stock prices requires a sustained decline in corporate earnings; the latter normally only happens during economic downturns. Admittedly, it is impossible to know for sure if a recession is lurking around the corner. If the Omicron variant is able to completely evade the vaccines, growth will slow considerably over the coming months. Yet, even in that case, the global economy is unlikely to experience a sudden-stop of the sort that occurred last March. As noted at the outset of this report, pharma companies have the tools to tweak the vaccines, and most experts believe that the soon-to-be-released antivirals will be effective against the new strain. If economic growth remains above trend, earnings will rise (Chart 41). S&P 500 companies generated $53.82 per share in profits in Q3. The bottom-up consensus is for these companies to generate an average of $54.01 in quarterly profits between 2021Q4 and 2022Q3, implying almost no growth from 2021Q3 levels. This is a very low bar to clear. We expect global equities to produce high single-digit returns next year. Chart 41Analysts Increased Earnings Estimates This Year The Beginning of the End Our guess is that 2022 will be the last year of the secular equity bull market that began in 2009. In mid-2023 or so, the Fed will come around to the view that the neutral rate is higher than it once thought. Unfortunately, by then, it will be too late; a wage-price spiral will have already emerged. A nasty bear flattening of the yield curve will ensue: Long-term bond yields will rise but short-term rate expectations will increase even more. A recession will follow in 2024 or 2025. The most important real-time indicator we are focusing on to gauge when to turn more bearish on stocks is the 5y/5y forward TIPS breakeven rate. As noted earlier, it is still at the bottom end of the Fed’s comfort zone. If it were to rise above 3%, all hell could break loose, especially if this happened without a corresponding increase in crude oil prices. The Fed takes great pride in the success it has had in anchoring long-term expectations. Any evidence that expectations are becoming unmoored would cause the FOMC to panic.   B. Equity Sectors, Regions, And Styles Favor Value, Small Caps, and Non-US Markets in 2022 Until the Fed takes away the punch bowl, a modestly procyclical stance towards equity sectors, styles, and regional equity allocation is warranted. Chart 42The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The relative performance of value versus growth stocks has broadly followed the trajectory of the 30-year Treasury yield this year (Chart 42). Rising yields should buoy value stocks, with banks being the biggest beneficiaries (Chart 43). In contrast, rising yields will weigh on tech stocks. Chart 43Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks   Chart 44The Winners And Losers Of Covid Waves If we receive some good news on the pandemic front, this should disproportionately help value. As Chart 44 illustrates, the relative performance of value versus growth stocks has tracked the number of new Covid cases globally. The correlation between new cases and the relative performance of IT and energy has been particularly strong. Rising capex spending will buoy industrial stocks. Industrials are overrepresented in value indices both in the US and abroad (Table 2). Along with financials, industrials are also overrepresented in small cap indices (Table 3). US small caps trade at 15-times forward earnings compared to 21-times for the S&P 500. Table 2Breaking Down Growth And Value By Sector Table 3Financials And Industrials Have A Larger Weight In US Small Caps Time to Look Abroad? Given our preference for cyclicals and value in 2022, it stands to reason that we should also favor non-US markets. Table 4 shows that non-US stock markets have more exposure to cyclical and value sectors. Table 4Cyclicals Are Overrepresented Outside The US Admittedly, favoring non-US stock markets has been a losing proposition for the past 12 years. US earnings have grown much faster than earnings abroad over this period (Chart 45). US stock returns have also benefited from rising relative valuations. Chart 45The US Has Been The Earnings Leader In Recent Years At this point, however, US stocks are trading at a significant premium to their overseas peers, whether measured by the P/E ratio, price-to-book, or price-to-sales (Chart 46). US profit margins are also more stretched than elsewhere (Chart 47).   Chart 47US Profit Margins Look Stretched Chart 48Non-US Stocks Tend To Do Best When The US Dollar Is Weakening The US dollar may be the ultimate arbiter of whether the US or international stock markets outperform in the 2022. Historically, there has been a close correlation between the trade-weighted dollar and the relative performance of US versus non-US equities (Chart 48). In general, non-US stocks do best when the dollar is weakening. The usual relationship between the dollar and the relative performance of US and non-US stocks broke down in 2020 when the dollar weakened but the tech-heavy US stock market nonetheless outperformed. However, if “reopening plays” gain the upper hand over “pandemic plays” in 2022, the historic relationship between the dollar and US/non-US returns will reassert itself. As we discuss later on, while near-term momentum favors the dollar, the greenback is likely to weaken over a 12-month horizon. This suggests that investors should look to increase exposure to non-US stocks in a month or two. Around that time, the energy shortage gripping Europe will begin to abate, China will be undertaking more stimulus, and investors will start to focus more on the prospect of higher US corporate taxes.    C. Fixed Income Maintain Below-Benchmark Duration The yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium that compensates investors for locking in their savings at a fixed rate rather than rolling them over at the prevailing short-term rate. While expected policy rates have moved up in the US over the past 2 months, the market’s expectations of where policy rates will be in the second half of the decade have not changed much (Chart 49). Investors remain convinced of the secular stagnation thesis which postulates that the neutral rate of interest is very low. As for the term premium, it remains stuck in negative territory, much where it has been for the past 10 years (Chart 50). Chart 50Negative Term Premium Across The Board The Term Premium Will Increase The notion of a negative term premium may seem odd, as it implies that investors are willing to pay to take on duration risk. However, there is a good reason for why the term premium has been negative: The correlation between bond yields and stock prices has been positive (Chart 51). Chart 51Stocks And Bond Yields Have Not Always Been Positively Correlated When bond yields are positively correlated with stock prices, bonds are a hedge against bad economic news. If the economy falls into recession, equity prices will drop; the value of your home will go down; you may not get a bonus, or even worse, you may lose your job. But at least the value of your bond portfolio will go up! There is a catch, however: Bonds are a hedge against bad economic news only if that news is deflationary in nature. The 2001 and 2008-09 recessions all saw bond yields drop as the economy headed south. Both recessions were due to deflationary shocks: first the dotcom bust, and later, the bursting of the housing bubble. In contrast, bond yields rose in the lead up to the recession in the 1970s and early 80s. Bonds were not a good hedge against falling stock prices back then because it was surging inflation and rising bond yields that caused stocks to fall in the first place. This raises a worrying possibility that investors have largely overlooked: The term premium may increase as it becomes increasingly clear that the next recession will be caused not by inadequate demand but by Fed tightening in response to an overheated economy. A rising term premium would exacerbate the upward pressure on bond yields stemming from higher-than-expected inflation as well as upward revisions to estimates of the real neutral rate of interest. Again, we do not think that a “term premium explosion” is a significant risk for 2022. However, it is a major risk for 2023 and beyond. Investors should maintain a modestly below-benchmark duration stance for now but look to go maximally underweight duration towards the end of next year.   Global Bond Allocation BCA’s global fixed-income strategists recommend underweighting the US, Canada, the UK, and New Zealand in 2022. They suggest overweighting Japan, the euro area, and Australia. US Treasuries trade with a higher beta than most other government bond markets (Chart 52). Our bond strategists expect the US 10-year Treasury yield to hit 2%-to-2.25% by the end of next year. Chart 52High-And Low-Beta Bond Yields As discussed earlier, neither the ECB nor the BoJ are in a hurry to raise rates. Both euro area and Japanese bonds have outperformed the global benchmark when Treasury yields have risen (Chart 53). Chart 54UK Inflation Expectations Are Higher Than In Other Major Developed Economies While rate expectations in Australia have come down on the Omicron news, the markets are still pricing in four hikes next year. With wage growth still below the RBA’s target, our fixed-income strategists think the central bank will pursue a fairly dovish path next year. In contrast, they think New Zealand will continue its hiking cycle. Like Canada, the Reserve Bank of New Zealand has become increasingly concerned about soaring home prices and household indebtedness.  Inflation expectations are higher in the UK than elsewhere (Chart 54). With the BoE set to raise rates early next year, gilts will underperform the global benchmark.   Overweight High-Yield Corporate Bonds… For Now Chart 55High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% The combination of above-trend economic growth and accommodative monetary policy will provide support for corporate bonds in 2022. For now, we prefer high yield over investment grade. According to our bond strategists, while high-yield spreads are quite tight, they are still pricing in a default rate of 3.8% (Chart 55). This is more than their fair value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.7%.   As with equities, the bull market in corporate credit will end in 2023 as the Fed is forced to accelerate the pace of rate hikes in the face of an overheated economy and rising long-term inflation expectations.   D. Currencies and Commodities Dollar Strength Will Reverse in Early 2022 Since bottoming in May, the US dollar has been trending higher. The US dollar is a high momentum currency: When the greenback starts rising, it usually keeps rising (Chart 56). A simple trading rule that buys the dollar when it is trading above its various moving averages has delivered positive returns (Chart 57). This suggests that the greenback could very well strengthen further over the next month or two. Over a 12-month horizon, however, we think the trade-weighted dollar will weaken. Both speculators and asset managers are net long the dollar (Chart 58). Current positioning suggests we are nearing a dollar peak. Rising US rate expectations have helped the dollar this year. Chart 59 shows that both USD/EUR and USD/JPY have tracked the spread between the yield on the December 2022 Eurodollar and Euribor/Euroyen contracts, respectively. While the Fed will expedite the pace of tapering, the overall approach will still be one of “baby-steps” towards tightening next year. BCA’s bond strategists do not expect US rate expectations for end-2022 to rise from current levels. Chart 58Long Dollar Positions Are Getting Crowded Chart 59Interest Rates Have Played A Major Role On The Dollar's Performance This Year   The present level of real interest rate differentials is consistent with a much weaker dollar (Chart 60). Using CPI swaps as a proxy for expected inflation, 2-year real rates in the US are 42 basis points below other developed economies. This is similar to where real spreads were in 2013/14, when the trade-weighted dollar was 16% weaker than it is today. Chart 60AThe Dollar And Interest Rate Differentials (I) Chart 60BThe Dollar And Interest Rate Differentials (II) Meanwhile, growth outside the US will pick up next year as Europe’s energy crisis abates and China ramps up stimulus. If history is any guide, firmer growth abroad will put downward pressure on the dollar (Chart 61). Chart 61The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World Chart 62Dollar Headwinds Pricey Greenback The dollar’s lofty valuation has left it overvalued by nearly 20% on a Purchasing Power Parity (PPP) basis. The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply. Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 62). However, these inflows are starting to abate, and could drop further if global investors abandon their infatuation with US tech stocks.   Favor Commodity Currencies We favor commodity currencies for 2022, especially the Canadian dollar, which we expect to be the best performing G10 currency. Canadian real GDP growth will average nearly 5% in Q4 and the first half of next year. The Bank of Canada will start hiking rates next April. Oil prices should remain reasonably firm next year, helping the loonie and other petrocurrencies. Bob Ryan, BCA’s chief Commodity Strategist, expects the price of Brent crude to average $80/bbl in 2022 and 81$/bbl in 2023, which is well above the forwards (Chart 63). Years of underinvestment in crude oil production have led to tight supply conditions (Chart 64). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by Chinese fiscal stimulus. Looking further ahead, the outlook for metals remains bright. Whereas the proliferation of electric vehicles is bad news for oil demand over the long haul, it is good news for many metals. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   The RMB Will Be Stable in 2022 It is striking that despite the appreciation in the trade-weighted dollar since June and escalating concerns about the health of the Chinese economy, the RMB has managed to strengthen by 0.3% against the US dollar. Chinese export growth will moderate in 2022 as global consumption shifts from goods to services. Rising global bond yields may also narrow the yield differential between China and the rest of the world. Nevertheless, we doubt the RMB will weaken very much. China wants the RMB to be a global reserve currency. A weak RMB would run counter to that goal. Rather than weakening the yuan, the Chinese authorities will use fiscal stimulus to support growth.   Gold Versus Cryptos? Gold prices tend to move closely with real bond yields (Chart 65). Since August 2020, however, the price of gold has slumped from a high of $2,067/oz to $1,768/oz, even though real yields remain near record lows. The divergence between real yields and gold prices may partly reflect growing demand for cryptocurrencies. Investors increasingly see cryptos as not just a disruptive economic force, but as the premier “anti-fiat” hedge. Whether that view pans out remains to be seen. So far, the vast majority of the demand for cryptocurrencies has stemmed from people hoping to get rich by buying cryptos. To the extent that people are using cryptos for online purchases, it is usually for illegal goods (Chart 66).  Chart 65Gold Prices Tend To Correlate Closely With Real Interest Rates Crypto proponents like to say that the supply of cryptos is finite. While this may be true for individual cryptocurrencies, it is not true for the sector as a whole. Over the past 8 years, the number of cryptocurrencies has swollen from 26 in 2013 to 7,877 (Chart 67). At least with gold, they are not adding any new elements to the periodic table. At any rate, the easy money in the crypto space has already been made. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.2 trillion, equal to the entire stock of US dollars in circulation. Investors looking to hedge long-term inflation risk should shift back into gold. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Long-term investors should place up to 5 percent of their assets in cryptocurrencies. As the drawdown risk of owning cryptocurrencies converges with that of owning gold, the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market… … with BTC, ETH, and the others taking a third of this half – $2 trillion – each. This means that BTC would double to $120,000, while ETH would quadruple to $17,000. Some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. Underweight gold relative to the other precious metals. As cryptocurrencies eat more of gold’s lunch, gold is set to become a pale shadow of its former self. Fractal analysis: Coffee and Cameco. Feature Chart of the WeekCryptos Are Eating Gold's Lunch... And There's Plenty More To Eat If you’re wondering just how the market value of cryptocurrencies has surged to $2.5 trillion today from $0.5 trillion barely eighteen months ago, there’s a simple answer. Cryptocurrencies have eaten gold’s lunch – displacing almost $2 trillion from the investment value of the yellow metal. And that’s just so far… Given that the investment value of gold still stands at $9.5 trillion, there is plenty more of gold’s lunch that cryptocurrencies can eat (Chart of the Week). As Mark Twain might put it, rumours of crypto’s demise have been greatly exaggerated. When cryptocurrency prices corrected by 50 percent in May this year, the obituary writers got busy. For the 419th time. But since their birth in 2007, every time that they have ‘died’, cryptocurrencies have proved their detractors wrong, with prices quickly resurrecting and reaching new highs. We expect this pattern to continue (Chart I-2). Chart I-2Rumours Of Crypto's Demise Have Been Greatly Exaggerated Cryptocurrencies And Blockchains Are Joined At The Hip To understand the investment case for cryptocurrencies, it is important to realise that the success of a cryptocurrency and the success of its blockchain are inextricably linked. Yet what confuses this matter is that for the best known cryptocurrency of all – Bitcoin – the relationship between the cryptocurrency and its blockchain is ‘back-to-front’. Bitcoin is first and foremost a cryptocurrency BTC, which is secured (against double-spending) by its blockchain network. Meaning that BTC is the main act, and the Bitcoin blockchain is the supporting act. However, for most other cryptocurrencies, the opposite is true. The blockchain is the main act, and the cryptocurrency is the supporting act. For example, Ethereum is first and foremost a blockchain network – a decentralised intermediator of services such as smart-contracts or bond-issuance through decentralised finance (DeFi). Note that over $5 billion of bonds have already been issued on Ethereum and other blockchains, including by the European Investment Bank, the World Bank, and the Bank of China. The users of the Ethereum intermediation services pay the users of Ethereum that validate them in its cryptocurrency, ETH. Crucially, this ability to exchange ETH (and other cryptocurrencies) for intermediation services on the associated blockchain gives the cryptocurrency an economic utility. This economic utility means that the cryptocurrencies of successful blockchain networks can be thought of as ‘digital gold’. Gold derives its utility from its physical attributes – beauty, wear-ability, and electrical conductivity. Whereas, the cryptocurrencies of successful blockchains derive their utility from their means of exchange for the useful intermediation services that the blockchains provide. Furthermore, just as governments and central banks cannot determine the supply of gold, neither can they determine the supply of successful cryptocurrencies. This last point is important because most of the current value of gold comes not from its beauty, wear-ability, and electrical conductivity, but from its investment value as a hedge against the debasement of fiat money. The immediate investment case for cryptocurrencies is that they are set to displace much of this investment value from gold (Chart I-3). Chart I-3Cryptocurrencies Are Displacing Gold's Investment Value Cryptocurrencies Are Displacing Gold As The Anti-Fiat Hedge. Gold is scarce, but we can quantify its scarcity. Geology tells us that, in the earth’s crust, gold is 15 times as scarce as silver. And chemistry tells us that gold sits directly beneath silver in group 11 of the periodic table, meaning that the chemistry to extract gold and silver from their ores is essentially the same. Therefore, based on the geology and chemistry of the precious metals, gold should trade at around 15 times the price of silver. And 15 times the price of silver is precisely where gold did trade for centuries, and broadly where it traded in 1970. Yet by the mid-1970s the gold-to-silver ratio had breached 45, and by the late-1980s it had breached 75, where it stands today (Chart I-4). Why? Chart I-4Gold’s Massive Premium Versus Its Geological And Chemical Fundamentals Comes From Its Investment Value (As A Hedge Against The Debasement Of Fiat Money) The gold-to-silver ratio surged because, in 1971, the Bretton Woods ‘pseudo gold standard’ collapsed and the world economy moved to a fiat monetary system. Lest there is any doubt, a similar surge happened forty years earlier in 1931 when the original gold standard collapsed, before being reconstructed at the Bretton Woods conference in 1944. From these two surges, we can deduce that the premium in gold’s value versus its geological and chemical fundamentals constitutes its insurance policy value against the debasement of fiat money. Some people counter that only a small proportion of gold is owned as an explicit investment, and a large proportion is owned for its beauty and status. Yet this has been the case for millennia, and through most of this history gold-to-silver has traded in line with its geological and chemical fundamentals. Given that the gold price surges post-1931 and post-1971 coincided almost precisely with the introduction of fiat money, it is gold’s insurance policy value against the debasement of fiat money that is setting most of its current value. Based on the gold-to-silver ratio of 75 versus the geological and chemical fundamental value of 15, we can deduce that around four-fifths of gold’s $12 trillion above ground market value, or $9.5 trillion, comes from its insurance policy value. Add to that the current $2.5 trillion value of cryptocurrencies, and we can estimate that the total ‘anti-fiat’ investment market is worth $12 trillion. Of which, gold comprises around 80 percent, and cryptocurrencies around 20 percent. But to repeat, cryptocurrencies can eat much more of gold’s lunch (Chart I-5). Chart I-5Cryptocurrencies Can Eat Much More Of Gold's Lunch The Investment Implications: Bitcoin To $120,000, Ethereum To $17,000 We estimate that absent the displacement of investment value into cryptocurrencies since mid-2020, gold would now be trading at an all-time high of $2150 instead of at $1800. But given that there is much more of gold’s lunch for cryptocurrencies to eat, gold is set to become a pale shadow of its former self. Investors should underweight gold relative to the other precious metals. One pushback we get is that governments will ultimately issue a blanket ban on cryptocurrencies. But our pushback to the pushback is that it is a contradiction to be pro-blockchain and the anti- the ‘joined at the hip’ cryptocurrency which secures and validates the transactions on that blockchain. To resolve this contradiction, governments will try and regulate, rather than ban, cryptocurrencies. Another obvious question is: if Bitcoin is ‘back-to-front’ with its underlying blockchain having less utility and versatility than Ethereum and most other cryptocurrencies, should we still own BTC? The answer is yes, for two reasons. First, in time, the Bitcoin blockchain is likely to become more versatile; second, there will be some investors who hold out for the very long-term possibility that a cryptocurrency does displace fiat money. In which case, BTC would be the prime candidate. As the drawdown risk of owning cryptocurrencies converges with that of owning gold (Chart I-6), the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market, with BTC, ETH, and the others taking a third of this half – $2 trillion – each. Although BTC would become a smaller slice of the pie, the pie would be much bigger. From current market values, this means that BTC would double to $120,000. Chart I-6Cryptocurrency Corrections Are Becoming Less Extreme But the real action would be in the other cryptocurrencies. ETH would quadruple to $17,000, while some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. In conclusion, we expect the cryptocurrency asset-class to continue its strong structural uptrend, punctuated by short sharp corrections. As such, long-term investors should place up to 5 percent of their assets in cryptocurrencies. Coffee Is Too Expensive In this week’s fractal analysis, we make two observations: First, for those who want a second bite at the cherry for shorting the uranium meme theme, the spectacular rally in the Canadian stock Cameco offers a good opportunity – given its very fragile 260-day fractal structure, which has successfully signalled five previous turning-points (Chart I-7). Chart I-7Cameco Is Overbought Second, within the soft commodities, the spectacular rally in coffee combined with the recent sell-off in cocoa has stretched the relative pricing of the two softs to a 10-year extreme, as well as a very fragile 260-day fractal structure (Chart I-8). Chart I-8Coffee Is Too Expensive Accordingly, this week’s recommended trade is to short coffee versus cocoa, setting a profit-target and symmetrical stop-loss at 30 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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  

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 18US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 22Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 25Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights There is a high risk of a global demand shortfall in 2022. This is because consumer demand for services will remain well below its pre-pandemic trend… …while the recent booming demand for goods is crashing back to earth. Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Fractal analysis: Overweight gas distribution. Feature Chart of the WeekSpending On Services In The US Is Still Far Below The Pre-Pandemic Trend. Will It Catch Up In 2022? With inflation surging, you would be forgiven for thinking that global demand is red-hot. Sadly, global demand is not red-hot. Two years after the pandemic began, the lynchpin of demand – consumer spending on services – remains far below its pre-pandemic trend. For example, US consumer spending on services is around $420 billion, or 5 percent, below where it should be (Chart I-1). A similar story holds true in the UK and France (Chart I-2 and Chart I-3). Chart I-2Spending On Services Is Still Far Below The Pre-Pandemic Trend In The UK... Chart I-3...And France Still, overall US consumer spending is on trend. Just. But only thanks to an unprecedented largesse of fiscal and monetary stimulus. Begging the question, what will happen when the stimulus ends? If overall stimulated spending is just on trend while spending on services is in deficit, it means that spending on goods is in a mirror-image $420 billion surplus. Which, given the smaller share of spending on goods, equates to 8 percent above where it should be. One misconception is that the surplus in goods spending is concentrated in durables. While this was true six months ago, two-thirds of the current surplus is in nondurables, dominated by clothing and shoes, food and drink at home, and games, toys and hobbies (Chart I-4). Chart I-4US Overspend On Durables Is Now $140 Bn, While Overspend On Nondurables Is $280 Bn Looking ahead, if the demand for goods crashes back to earth, as seems to be happening now, then the demand for services will have to catch up to its pre-pandemic trend. Otherwise there will be a deficit in aggregate demand. So, the crucial question for 2022 is, will services spending catch up to its pre-pandemic trend? Services Spending Will Remain Well Below Its Pre-Pandemic Trend Many people believe that the deficit in US services spending is due to the underspend in bars, restaurants, and hotels. In fact, this is another misconception. The underspending on ‘food services and accommodations’ is now a negligible $30 billion out of the $420 billion deficit. In which case, where is the deficit? Surprisingly, the biggest component is a $160 billion underspend on health care (Chart I-5). In particular, the spending on ‘outpatient physician services’ levelled off a year ago well below its pre-pandemic level (Chart I-6). A plausible explanation is that many doctor’s appointments have shifted to online, requiring much lower spending. The result is that health care consumption has slowed its convergence to the pre-pandemic trend, implying that a deficit could be persistent. Chart I-5US Underspend On Health Care ##br##Is $160 Bn Chart I-6US Spending On Physician Services Is Far Below The Pre-Pandemic Trend A second major component of the deficit is a $110 billion underspend on recreation services, as consumers have shunned the large or dense crowds in amusement parks, sports centres, spectator sports, and theatres. Some of this shunning of crowds will be long-lasting (Chart I-7). Chart I-7US Underspend On Recreation Services Is $110 Bn A third major component of the deficit is a $60 billion underspend on public transportation, as people have likewise shunned the personal proximity required in mass transit systems and aeroplanes. Some of this shunning of transport that requires personal proximity will also be long-lasting (Chart I-8). Chart I-8US Underspend On Public Transportation Is $60 Bn Worryingly, the recent spending on both recreation services and public transportation has stopped converging with the pre-pandemic trend. Admittedly, this might be a blip due to the delta wave of the pandemic, and spending could re-accelerate once this wave subsides. On the other hand, it would be prudent to assume that the delta wave was not the last wave of the pandemic and that further waves could arrive in 2022. Pulling all of this together, large parts of services spending will remain persistently below their pre-pandemic trend. Eventually, new and innovative types of services will plug this deficit, but this will take time. Therefore, we conservatively estimate that, at the end of 2022, US consumer spending on services will still be below its pre-pandemic trend by at least $200 billion, or 2.5 percent. Other major economies, like the UK and France, will suffer similar deficits. Goods Spending Will Crash Back To Earth Let’s now switch to the other side of the ledger, and assess to what extent the underspend in services can be countered by an overspend in goods. Spending on durables is already crashing back to earth. A surplus of $500 billion in March has collapsed to $140 billion now, and we fully expect it to fall back to zero. The reason is that durables, by their very definition, provide long-duration utility. Meaning that there are only so many cars, smartphones, and gadgets that any person can own. But what about the current $280 billion surplus on nondurables – can that be sustained? The biggest component of the nondurables surplus is a $85 billion, or 20 percent, overspend on clothes and shoes. Some of this overspend is justified by a wardrobe transition to the post-pandemic way of working and living. But clothes and shoes, though classified as nondurable, are in fact quite durable. Meaning that once the wardrobe transition is complete, we do not expect people to spend 20 percent more on clothes and shoes than they did before the pandemic (Chart I-9). Chart I-9US Overspend On Clothes And Shoes Is $85 Bn A second major component of the nondurables surplus is a $75 billion, or 7 percent, overspend on food and beverages at home. To a large extent, this has been a displacement of the underspending on eating and drinking out. But given that this underspend on eating and drinking out has almost normalised, we expect the overspend on eating and drinking at home to fade (Chart I-10). Chart I-10US Overspend On Food And Drink At Home Is $75 Bn A third major component of the nondurables surplus is a $45 billion, or 16 percent, overspend on recreational items: games, toys, hobbies, and pets and pet products (Chart I-11 and Chart I-12). To a large extent, this has been a displacement of the underspend on recreation services involving crowds, which will last. Hence, we expect the nondurable surplus on recreational items also to last, to the benefit of the animal care sector and the interactive (electronic) entertainment sector. Chart I-11US Overspend On Games, Toys, And Hobbies Is $45 Bn Chart I-12Spending On Pets Is ##br##Booming Pulling all of this together, we expect the $140 billion surplus on durables to disappear fully, and the $280 billion surplus on nondurables to fade to well below $200 billion. Therefore, given that the deficit on services is likely to be above $200 billion, there is a high risk of a consumer demand deficit in 2022. Four Investment Conclusions The ultra-long end of the bond market is figuring out that without sustained above-trend demand, you cannot get sustained inflation. And to repeat, if demand is barely on trend after an unprecedented largesse of fiscal and monetary stimulus, then what will happen when the stimulus ends? All of which leads to four investment conclusions: Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Gas Distribution Is Oversold Finally, one of the paradoxes of skyrocketing natural gas prices is that it has badly hurt the gas distributors which, for the most part, have not been able to pass on the higher prices in full to end users. The resulting margin squeeze has caused a sharp recent underperformance, which is now fragile on its 65-day/130-day composite fractal structure (Chart I-13). Chart I-13Gas Distribution Is Oversold Given this fractal fragility combined with the recent correction in natural gas prices, a recommended trade would be to overweight global gas distribution versus banks, setting a profit target and symmetrical stop-loss at 5 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields ##br##- Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Special Report

In this report we examine the risk of stagflation by comparing the current environment to that of the late-1960s and 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part due to strong goods demand and supply disruptions that will eventually dissipate, and economic agents do not expect severe price pressures to persist beyond the pandemic. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not a likely event. Investors should use the Misery Index, which is the sum of the unemployment rate and headline PCE inflation, as a real-time stagflation indicator. The Misery Index underscores that the US economy is unlikely to experience true stagflation unless the unemployment rate rises. A portfolio of the US dollar, the Swiss Franc, and industrial commodities may serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-1The Misery Index Reflects The Risk Of Stagflation Over the past several weeks, concerns about a possible return to 1970s-style stagflation have re-emerged significantly in the minds of many investors. These investors have pointed toward similarities between the current environment and that of the 1970s, including shortages limiting output, a snarled global trade and logistical system, and rising energy prices. Chart II-1 highlights that the US “Misery Index” – the sum of the unemployment rate and headline PCE inflation – rose again over the past several months to high single-digit territory, after having fallen dramatically from April 2020 to February of this year. Panel 2 of Chart II-1 highlights that last year's rise in the Misery Index was driven almost entirely by the unemployment rate, whereas the current level is due to a combination of a modestly elevated unemployment rate and a pronounced acceleration in inflation. The headline PCE deflator has risen above 4%, a level that has not been reached since 1991 during the First Gulf War. In this report, we examine the risk of stagflation by comparing the current environment to that of the late 1960s and 1970s. We conclude that while investors cannot rule out the possibility of a stagflationary outcome, there are important differences that point toward a stagflation outcome over the coming 6-24 months as a risk, not a likely event. We conclude by highlighting assets that may produce absolute returns in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Revisiting The 1960s And 70s Chart II-2The 1960s Laid The Groundwork For Elevated Inflation The first step in judging the risk of a return to 1970s-style stagflation is to review, in a detailed way, what caused those conditions. Investors are well aware of the role that two separate energy price shocks played in raising prices and damaging output during this period, but they are less cognizant of the impact that a persistent period of above-trend output and significant labor market tightness had in setting up the conditions for sharply higher inflation. This focus of investors on energy prices partially reflects the fact that the Misery Index increased most visibly in the 1970s and that policymakers in the 1960s may not have realized how extensively economic output was running above its potential. With the benefit of hindsight, Chart II-2 illustrates the extent to which inflationary pressures built up in the 1960s, well before the first oil price shock in 1973. The chart shows that the unemployment rate was below NAIRU – the non-accelerating inflation rate of unemployment – for 70% of the time during the 1960s, and that inflation had already responded to this in the latter half of the decade. Annual headline PCE inflation was running just shy of 5% at the onset of the 1970 recession; it fell to 3% in the aftermath of the recession, but had already begun to reaccelerate in the first half of 1973. Following the 1973/1974 recession, inflation did decelerate significantly, falling from 11-12% to 5% in headline terms, and from 10% to 6% in core terms. But the pace of price appreciation did not fall below 5-6% in the second half of the 1970s, despite a significant and sustained rise in the unemployment rate above its natural rate. The 1975 to 1978 period is especially important for investors to understand, because it is arguably the clearest period of true stagflation in the 1970s. The fact that the Misery Index rose sharply during two major oil price shocks is not particularly surprising in and of itself, given the direct impact of energy prices on headline consumer prices; it is the fact that the index remained so elevated between these shocks, the result of persistently high inflation in the face of significant labor market slack, that is most relevant to investors. There are two reasons that both inflation and unemployment remained high during this period. First, labor market slack was sizeable during these years because the US economy was more energy-intensive in the 1970s than it is today. Chart II-3 highlights that goods-producing employment lagged overall employment growth from late 1973 to late 1977, underscoring that the rise in oil prices significantly impacted jobs growth in energy-intensive industries. Second, it is clear that the combination of demand-pull inflation in the late 1960s and the predominantly cost-push inflation of the 1970s led to expectations of persistent inflation among households and firms. The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. But the experience of the 1970s highlighted that inflation expectations are also an important determinant of inflation, a realization that gave birth to the expectations-augmented (i.e. “modern-day”) Phillips Curve (more on this below). The Stagflation Era Versus Today Table II-1 presents a stagflation “threat matrix,” representing the Bank Credit Analyst service’s assessment of the various factors that could potentially contribute to a stagflationary environment today, relative to what occurred in the 1960s and 1970s. While we acknowledge that there are some similarities today to what occurred five decades ago, the most threatening factors have been present for a shorter period of time and appear to have a smaller magnitude than what occurred during the stagflationary era. In addition, key factors, such as the visibility available to policymakers and investors about household inflation expectations and the potential output of the economy, would appear to reduce significantly the risk of a stagflationary outcome today. We discuss each of the factors presented in Table II-1 below: Fiscal & Monetary Policy Chart II-4Government Spending Last Cycle Looked Nothing Like The 1960s The persistently tight labor market that contributed to the inflationary buildup in the 1960s occurred as a result of easy fiscal and monetary policy. Chart II-4 highlights that the contribution to real GDP growth from government expenditure and investment was very elevated in the 1960s. Chart II-5 shows that a positive output gap in the late 1960s and the first half of the 1970s is well explained by the fact that 10-year US government bond yields were persistently below nominal GDP growth. The relationship between the stance of monetary policy and the output gap only meaningfully diverged in the latter half of the 1970s, during the true stagflationary era that we noted above. Chart II-5Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Chart II-6Monetary Policy Today Is Extremely Easy Today, it is clear that the stance of fiscal policy has recently been extraordinarily easy, and 10-year US government bond yields have remained well below nominal GDP growth for the better part of the last decade. Relative to estimates of potential nominal GDP growth, 10-year Treasury yields are the lowest they have been since the 1970s (Chart II-6). Ostensibly, this supports concerns that policy might contribute to a stagflationary outcome. These concerns were raised by Larry Summers in March, when he described the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 But there are two important counterpoints to these concerns. First, easy fiscal policy this cycle has followed a period during the last economic cycle in which government spending contributed to the most sustained drag on economic activity since the 1950s. Unlike the 1960s, the unemployment rate has been below NAIRU for only a third of the time over the past decade. In addition, Chart II-7 highlights that fiscal thrust will turn to fiscal drag next year, underscoring the temporary nature of the massive burst in fiscal spending that has occurred in response to the pandemic. Under normal circumstances, the fiscal drag implied by Chart II-7 would substantially raise the risks of a recession next year, but we have noted in previous reports that a significant amount of excess savings remain to support spending and employment. The net impact of these two factors results in a reasonable expectation that the US economy will return to maximum employment next year, but this is a far cry from the 1960s when the unemployment rate was below its natural rate for 70% of the decade. Based on conventional measures, US monetary policy has been easy for a decade, but easy monetary policy did not begin to contribute positively to a rise in household sector credit growth last cycle until 2014/2015. This underscores that the natural rate of interest (“R-star”) did fall during the early phase of the last economic expansion. However, we argued in an April report that R-star was likely rising in the latter half of the last expansion,2 and we believe that the terminal Fed funds rate is likely higher than what the Fed is currently projecting, barring any additional negative policy shocks. Thus, while we do not believe that the duration of easy monetary policy over the past decade has laid the groundwork for a major rise in prices, it is now clearly positively contributing to aggregate demand and does risk a future overshoot in prices if long maturity bond yields remain well below the pace of economic growth for a sustained period of time. The Impact Of Shortages Chart II-8Gasoline Shortages Plagued The US Economy In The 1970s Gasoline shortages occurred during the oil shocks of the 1970s and are a key similarity that some investors point toward when comparing the situation today with the stagflationary era. Chart II-8 highlights that the annual growth in real personal consumption expenditures on energy goods and services fell into negative territory on six occasions in the 1970s, although it was most pronounced during the two oil price shocks and their resulting recessions. Today, the impact of shortages appears to be broader than what occurred in the 1970s, but less impactful and not likely to be as long-lasting. Chart II-9 highlights that the OPEC oil embargo of 1973 raised the global oil bill by 2.4% of global GDP and permanently raised the price of oil. The global oil bill will only be fractionally above its pre-pandemic level in 2022, with oil prices at $80/bbl, and, while it is true that US gasoline prices have risen significantly, they are not higher than they were from 2011-2014 (Chart II-10). Chart II-9$80/bbl Oil Is Not Onerous Chart II-10US Gasoline Prices Are High, But They Have Been Higher It is certainly true that global shipping costs have skyrocketed and that this is contributing to the increase in US consumer prices. We estimate, however, that this increase in shipping costs as a share of GDP is no more than a quarter of the impact of the 1973 increase in oil prices, without the attendant negative effects on US goods-producing employment that occurred in the 1970s. If anything, surging shipping costs create an incentive to re-shore manufacturing production, which would contribute positively to US goods-producing employment. We also do not expect the rise in shipping costs to be meaningfully permanent, i.e., shipping costs may ultimately settle at a higher level than they were in late-2019, but at a much lower level than what prevails today. Chart II-11A Tight Labor Market Is Causing Wage Growth To Pick Up Semiconductor and labor shortages would appear to represent a more salient threat of stagflation in the US, as the domestic production of motor vehicles cannot occur without key inputs and a tight labor market is already contributing to an acceleration in wage growth (Chart II-11). As we noted in Section 1 of our report, auto production significantly impacted growth in the third quarter. However, Chart II-12 highlights that, for now, the breadth of impact of these shortages appears to be limited: the production component of the ISM manufacturing index remains in expansionary territory, industrial production of durable manufacturing excluding motor vehicles and parts has not broken down, and both housing starts and building permits remain above pre-pandemic levels despite this year’s downtrend in permits. Chart II-12Shortages Do Not Yet Seem To Be Broad-Based A physical shortage of components is a less relevant factor for the services side of the economy, which appears to have re-accelerated meaningfully in October. The services sector is more considerably impacted by shortages in the labor market, which seem to be linked to a still-low labor force participation rate. We noted in our September report that the decline in the participation rate has significantly overshot what would be implied by the ongoing pace of retirements. Chart II-13 highlights that this has occurred not just because of a significant retirement effect, but also because of the shadow labor force (people who want a job but are not currently looking for work) and family responsibilities. We expect that the recent expiry of expanded unemployment insurance benefits, a steady rise in the immunity of the US population, an abating Delta wave of COVID-19, and a likely upcoming reduction in school/classroom closures once the Pfizer/BioNTech vaccine is approved for school-age children will likely ease the labor shortage issue over the coming several months. Output Gap Uncertainty It remains a debate among economists why policymakers maintained such easy monetary policy in the 1960s and 1970s, but Chart II-14 highlights that uncertainty about the size of the output gap may have contributed to too-low interest rates. The chart shows the unemployment rate compared with today's estimate of NAIRU, alongside a simple proxy for policymakers’ real time estimate of the natural rate of employment: the cumulative average unemployment rate in the post-war environment. To the extent that policymakers used past averages of the unemployment rate as their guide for NAIRU, Chart II-14 highlights how they may have underestimated the degree to which output was running above its potential level in the 1960s, and would not have even concluded that output was above potential in the early 1970s. Chart II-14Policymakers Overestimated Labor Market Slack In The 60s And 70s Chart II-15Policymakers Know That NAIRU Is Likely At Or Below 4% Today, the environment is quite different, because the acceleration in wage growth at the tail end of the last expansion gives policymakers and investors a good estimate of where NAIRU is. Chart II-15 highlights that wage growth accelerated in 2018/2019 in response to a sub-4% unemployment rate, which is consistent with both the Fed’s NAIRU estimate of 3.5-4.5% and Fed Vice Chair Richard Clarida’s expressed view that a 3.8% unemployment rate likely constitutes maximum employment (barring any issues with the breadth and inclusivity of the labor market recovery). It is possible that the pandemic has structurally lowered potential output, which could mean that policymakers may no longer rely on the wage growth / unemployment relationship that existed in the latter phase of the last expansion. However, we do not find any credible arguments that would support the notion of a structurally lower level of potential output: the pandemic is likely to end at some point in the not-too-distant future, the negative impact of working-from-home policies on office properties and employment in central business districts is not sizeable,3 and productivity may have permanently increased in some industries because of the likely stickiness of a hybrid work culture. The Behavior Of Inflation Expectations Chart II-16Rising Long-Term Expectations Have Merely Normalized (For Now) One parallel to the argument that policymakers may have underestimated the degree of labor market tightness in the 1960s and early 1970s is the fact that they did not yet understand that inflation expectations are an important determinant of actual inflation, nor were they able to monitor them even if they did. Most credible surveys of inflation expectations began in the 1980s, and policymakers in the 1960s and 1970s were guided by the original Phillips Curve that solely related inflation to unemployment. Today, policymakers have the experience of the stagflationary episode to serve as a warning not to allow inflation expectations to get out of control, and both policymakers and investors have reliable measures of inflation expectations for households and market-participants. Chart II-16 highlights that households expect significant inflation over the coming year, but also expect prices over the longer term to rise at a pace that is almost exactly in line with their average from 2000-2014. The Rudd Controversy: (Adaptive) Inflation Expectations Do Matter One potential criticism of the idea that inflation expectations are signaling a low risk of higher future inflation has emerged through arguments made by Jeremy Rudd, a Federal Reserve economist. In a recent paper, Rudd questioned the view that households’ and firms’ expectations of future inflation are a key determinant of actual inflation; he suggested instead that relatively stable inflation since the mid-1990s might reflect a situation in which inflation simply does not enter workers’ employment decisions and expectations are irrelevant. Rudd’s paper was primarily addressed to policymakers who view inflation dynamics in a highly quantitative light. A full response to the paper would be mostly academic and thus not especially relevant to investors; however, we would like to highlight three points related to the Rudd piece that we feel are important.4 First, we disagree with Rudd’s argument that the trend in inflation has not responded to changes in economic conditions since the mid-1990s. Chart II-17 highlights that while the magnitude of the relationship has shifted, the trend in inflation relative to a measure of long-term expectations based on prior actual inflation has mimicked that of the output gap. The fact that inflation was (ironically) too high during the early phase of the last economic cycle provides some support for Rudd’s inflation responsiveness view, although we would still point toward the Fed’s strong record of maintaining low and stable inflation, its active communication with the public in the years following the global financial crisis, and the fact that a recovery began and the output gap began to (slowly) close as the best explanation for the avoidance of deflation during that period. Second, we agree with Rudd’s point that regime shifts in inflation’s responsiveness to economic conditions can occur, and that adaptive measures of inflation expectations, and even surveys of inflation, may not capture such a shift in real time. Chart II-18 shows that the 2014-2016 period was a good example of this, when adaptive expectations as well as household survey measures of long-term inflation expectations both lagged the actual decline in inflation that was caused by a collapse in the price of oil. Chart II-17The Trend In Inflation Continues To Respond To Economic Conditions Chart II-18Surveyed Inflation Expectations Can Lag, But This Time They Led But Chart II-18 also shows that long-term household survey measures of inflation led the rise in actual inflation (and thus our adaptive expectations measure) last year, underscoring that these measures are likely more reliable indicators today of whether a major regime shift is occurring. As noted above, long-term expectations have risen significantly relative to what prevailed prior to the pandemic, but this has merely raised expectations from extraordinarily depressed levels back to the average that prevailed prior to (and immediately after) the global financial crisis. Therefore, household expectations are not yet at dangerous levels. Chart II-19Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Third, one of the core observations in Rudd’s paper is that unit labor cost (ULC) growth leads the trend in inflation, which he argued was evidence against the idea that expectations of future inflation are a key determinant of actual inflation. Chart II-19 highlights that Rudd is correct that ULC growth modestly leads inflation (especially core inflation), but we disagree with his conclusion that it argues against the importance of expectations. As we noted in Section 2 of our January 2021 Bank Credit Analyst,5 one crucial aspect of the expectations-augmented, or “modern-day” Phillips Curve is that, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. Our view is that ULC growth is fundamentally linked to slack in the labor market, which is directly incorporated in output gap measures. As we noted above, investors currently have a good estimate of the magnitude of the output/employment gap, meaning that it is possible to track the inflationary consequences of prevailing aggregate demand. As a final point about ULC growth, Chart II-19 highlights that while the five-year CAGR of unit labor costs is currently running at its strongest pace since the global financial crisis, investors should note that it remains well below the levels that prevailed in the late-1960s when persistently above-potential output laid the groundwork for a massive inflationary overshoot. Conclusions And Investment Strategy Our review of the 1960s and 1970s highlights that stagflation is a phenomenon in which supply-side shocks raise prices of key inputs to production, which lowers output and raises unemployment. Energy price shocks in the 1970s occurred after a long period of policy-driven above-trend growth in the 1960s, meaning that both demand-pull and cost-push inflation contributed to stagflation in the 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been very expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. Chart II-20It Is Not Stagflation If The Unemployment Rate Continues To Fall However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part the result of strong goods demand and disruptions that are clearly linked to the pandemic (and thus will eventually dissipate), and long-term inflation expectations are behaving differently than short-term expectations, signaling that economic agents do not expect severe price pressures to persist beyond the pandemic. Policymakers also have more visibility about the magnitude of economic / labor market slack than they did during the stagflationary era and better tools to track inflation expectations. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not as a likely event. Using the Misery Index as real-time stagflation indicator, investors should note that the US economy is not likely experiencing true stagflation unless the unemployment rate rises. Chart II-20 highlights that there is no evidence yet of a contraction in goods-producing or service-producing jobs. Even if goods-producing employment slows meaningfully over the coming few months as a result of component shortages, the unemployment rate is still likely to fall if services spending normalizes, as it would imply that the gap in services-producing employment, which is currently 20% of the level of pre-pandemic goods-producing employment, will continue to close. Investors have been focused on the issue of stagflation because its occurrence would imply a sharply negative correlation between stock prices and bond yields. This is not our base case view, but we have highlighted that months with negative returns from both stocks and long-maturity bonds tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). As we discussed in Section 1 of our report, we do expect the Fed to raise interest rates next year. We do not see a rise in bond yields to levels implied by the Fed’s interest rates projections as being seriously threatening to economic activity, corporate earnings growth, or equity multiples. But the adjustment to higher long-maturity bond yields may unnerve equity investors for a time, implying temporary periods of a negative stock price / bond yield correlation. Table II-2 highlights that, since 1980, commodities, the US dollar, and the Swiss franc have typically earned positive returns during non-recessionary months in which stock and long-maturity bond returns are negative. While the dollar is not likely to perform well in a stagflationary scenario, Chart II-21 highlights that CHF-USD and industrial commodities performed quite well in the late-1970s. As such, a portfolio of these three assets might serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-21The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2 Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst “Work From Home “Stickiness” And The Outlook For Monetary Policy,” dated June 24, 2021, available at bca.bcaresearch.com 4 Rudd, Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?),” Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System. 5  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December 18, 2021, available at bca.bcaresearch.com

Highlights The circumstances of the pandemic improved in October, but data highlighting the economic consequences of the Delta wave grew more severe. US economic activity slowed meaningfully in the third quarter, driven by lower car sales and a slowdown in services spending. The imminent vaccination of school-aged children, and signs that services activity and spending are increasing, will likely raise labor force participation, boost education employment, and hasten the return of real services spending back to pre-pandemic levels. Investors have the right bond view, but the wrong reason. Investors believe that the Fed will be forced to raise interest rates earlier than it currently expects to prevent an out-of-control rise in prices, whereas it will likely do so because of a quicker return to maximum employment. Bond yields are likely to move higher over the coming year, but this will be driven by real yields, not inflation expectations. Once the Fed begins to raise interest rates, investors should be on the lookout for signs that market expectations for the real natural rate of interest, or “R-star,” are rising. The Fed’s terminal rate projection is well below nominal potential GDP growth, and a gap between these two measures no longer makes sense. Stocks are likely to generate mid-single digit returns next year, which will beat the returns offered by bonds and cash. But stocks will generate much lower returns compared with those enjoyed by investors over the past year. A benign rise in long-maturity bond yields argues for the outperformance of value versus growth stocks over the coming year. Cyclical stocks are now becoming stretched versus defensives on an equally-weighted basis; stay overweight for now, but a downgrade to neutral may be in the cards at some point next year. Feature Chart I-1The Waning Impact Of Delta Over the past month, the focus of investors has shifted from day-to-day developments to the consequences of the Delta wave of the pandemic. Chart I-1 highlights that, while an estimate of the COVID-19 reproduction rates in advanced economies has recently inched higher, it remains below one and hospitalizations continue to trend lower in most major economies. UK hospitalizations have increased over the course of the month, but remain at a level that is a quarter of their January peak – despite an elevated pace of confirmed cases. In the US, both these cases and hospitalizations continue to fall, trends that are likely to be reinforced by the vaccination of children over the coming weeks. A 50-60% vaccination rate for school-aged children would increase the US vaccination rate by 4-5 percentage points. Vaccinating all children at this rate would increase the total vaccination rate by 7-8 percentage points. In combination with a meaningful level of natural immunity, the vaccination of children is likely to bring the US very close to, if not above, the non-accelerating hospitalization rate of immunity (or “NAHRI”).1 The Delta Hangover While the circumstances of the pandemic improved in October, the economic consequences grew more severe. US economic activity slowed meaningfully in the third quarter, as highlighted by yesterday’s advance release. Chart I-2 highlights that durable goods spending subtracted almost three percentage points from Q3 growth, and that most other components of GDP contributed less to growth in Q3 than in Q2. The significant slowdown in Q3 growth is disappointing, but several factors point toward the conclusion that it is not likely to be sustained: Chart I-3Services PMIs Are Pointing To A Stronger Q4 The Delta wave very likely impacted services spending, which we have highlighted is likely to drive overall consumption over the coming year. Given the ongoing impact of semiconductor shortages on the availability of new cars, it is not surprising that a slowdown in services spending resulted in a significant slowdown in overall growth. After having declined significantly in Q3, Chart I-3 highlights that the US, UK, French, and Japanese October flash services PMI rose anew, underscoring that recent services weakness have been closely linked to the Delta variant of COVID-19 (whose impact is now waning). Chart I-3 also highlights that the US services PMI is currently at a level that has been historically consistent with solid real PCE growth. Finally, while it is true that manufacturing PMIs are being supported by supplier deliveries components, the October output component of the US Markit manufacturing index remained in expansionary territory, as was the case in Germany, Japan, and the UK (despite month-over-month declines in these components). Chart I-4 highlights that Q3’s real GDP reading was highly anomalous relative to the pace of jobs growth in the quarter, based on the relationship between the two since the global financial crisis. In quarters in which real GDP growth was 1% or less than implied by the trendline shown in Chart I-4, real GDP accelerated in the subsequent quarter 80% of the time. In conjunction with a pickup in services activity in October, this suggests that growth will be meaningfully stronger in Q4. Chart I-5Global Growth Is Peaking, But A Major Downturn Is Unlikely Chart I-5 shows our global Nowcast indicator, alongside our global LEI. Our Nowcast indicator is a high-frequency measure of economic activity that is designed to predict global industrial production. The chart shows that both the Nowcast and global LEI are declining, but that this decline is occurring from an extremely elevated level. The global economy is at an inflection point in terms of the pace of growth, but Chart I-5 still points to above-trend growth – and certainly not a major cyclical downturn. The expectation of a slowdown in growth in Q3 has significantly raised concerns about a possible return to 1970s-style stagflation in the minds of many investors. We address this topic in depth in this month’s Special Report, and conclude that, while investors cannot rule out the possibility of stagflation, there are important differences that point toward a stagflationary outcome over the coming 6-24 months as a risk, not a likely event. We note in our report that the risk of stagflation can be monitored in real time by tracking the Misery Index, which is the sum of headline PCE inflation and the unemployment rate. Currently, the Misery Index is elevated relative to the average of the past 30 years, but it is meaningfully lower than it was during the latter half of the 1970s. This also underscores that true stagflation is only likely to occur if the unemployment rate rises, which means that the economic and financial market outlook over the coming year is strongly tied to the pace of jobs growth (even more so than usual). Table I-1 presents an industry breakdown of the jobs gap relative to pre-pandemic levels, sorted by industries with the largest gap. The table highlights that leisure and hospitality, government, and education and health services jobs continue to account for two-thirds of the five million jobs gap, with the latter two largely reflecting the same effect: 60% of the government jobs gap is accounted for by state and local government education-related employment. Chart I-6Leisure And Hospitality Employment Tracks The Hotel Occupancy Rate US education employment has been impacted by school and classroom closures, which we noted above are likely to end once school-aged children are vaccinated against the disease. Chart I-6 highlights that leisure and hospitality employment is clearly predicted by the US hotel occupancy rate, which wobbled over the past few months as a result of the Delta wave of the pandemic. Correspondingly, monthly growth in leisure and hospitality employment slowed in August and September. Taken together, the imminent vaccination of school-aged children and signs that services activity and spending are increasing will likely raise labor force participation, boost education employment, and hasten the return of real services spending back to pre-pandemic levels. The Bond Market Outlook Chart I-7The Market Now Agrees With Us About The Timing Of Fed Rate Hikes... A continued normalization of the labor market over the coming 6-12 months argues in favor of Fed rate hikes next year, which is a view that we have maintained for several months. Recently, investors have come to agree with us, by moving forward their expectations for the Fed funds rate (Chart I-7). However, Chart I-8 highlights that investors have the right view for the wrong reason. The chart highlights that US government bond yields have risen entirely due to inflation expectations and that real yields have fallen. This means that investors believe that the Fed will be forced to raise interest rates earlier than it currently expects to prevent an out-of-control rise in prices, whereas we believe that they will do so because of a return to maximum employment. The implication for investors is that bond yields are still likely to rise over the coming year, but that higher yields are likely to occur alongside falling inflation expectations. This trend underscores that common hedges against inflation, such as precious metals and the relative performance of TIPS, are likely to underperform over the coming year. We have noted in previous reports that the fair value for long-maturity government bond yields implied by the Fed’s interest rate projections is not likely threatening for equity multiples, and certainly not for economic activity. A September 2022 rate hike, coupled with a pace of three hikes per year and a 2.5% terminal Fed funds rate, implies that 10-year Treasury yields will rise to 2.15% over the coming year, which would be only modestly higher than the level that prevailed prior to the pandemic (Chart I-9). Chart I-8...But For The Wrong Reason Chart I-9Higher Bond Yields Are Unlikely To Be Restrictive Next Year   However, once the Fed begins to raise interest rates, investors should be on the lookout for signs that market expectations for the real natural rate of interest, or “R-star,” are rising. The Fed’s terminal rate projection is well below nominal potential GDP growth, and, while a gap between these two measures made sense in the years following the global financial crisis, this no longer appears to be the case. Chart I-10 highlights that real household mortgage liabilities began to contract sharply in 2006, and did not turn positive on a year-over-year basis until the end of 2016. It is likely that R-star was falling or weak during this period, but the correlation between the two series clearly shifted in the latter phase of the last economic cycle. Chart I-11 emphasizes this point by highlighting that the household debt service ratio is now the lowest it has been since the 1970s, underscoring the capacity that US consumers have to withstand higher interest rates. Chart I-10R-star Fell Post-GFC, For A Time Chart I-11Today, US Households Have A Lot Of Capacity To Tolerate Higher Rates     We doubt that investor expectations for the terminal rate will rise significantly before the Fed begins to normalize monetary policy, but it may happen. In addition, the Fed may begin raising interest rates next year as soon as late in the summer or early in the fall, which would locate the liftoff date within our 6-12 month investment time horizon. As such, our base case view is that a rise in interest rates over the coming year will not be threatening to the equity market, but this view may change at some point next year. Equities: Expect Modest Returns In 2022 A benign increase in long-maturity bond yields in 2022 suggests that equity multiples will neither contribute to, nor subtract from, equity returns. As such, return expectations for equities should be centered around expected earnings growth. Table I-2 presents consensus estimates for nominal GDP growth, S&P 500 revenue growth, and earnings growth for 2022. The table highlights that expectations for revenue growth estimates appear to be reasonable, given that bottom-up analysts continue to expect an expansion in profit margins next year. Chart I-12 highlights that margins have already risen back above their pre-pandemic high, and that this is true for both tech and ex-tech sectors. Chart I-12US Profit Margins Have Already Risen To Record Levels We doubt that further increases in profit margins will be sustained next year. It is possible that margins will actually decline – a view that was recently espoused by our US Equity Strategy service.2 Risks to profit margins underscore that stocks are likely to generate mid-single digit returns next year, which will beat the returns offered by bonds and cash. But stocks will generate much lower returns compared with those enjoyed by investors over the past year. Within the equity market, we remain of the view that even a benign rise in long-maturity bond yields argues for the outperformance of value versus growth stocks over the coming year. Chart I-13 highlights that the rolling one-year correlation between relative global growth versus value stock prices and the US 10-year Treasury yield has become increasingly negative over time, which bodes well for value. We also continue to recommend that investors favor small over large caps and cyclicals over defensives, although cyclical stocks are now becoming stretched versus defensives on an equally-weighted basis as they are closing in on their 2018 highs (Chart I-14). We think it is too early to position against cyclicals, but a downgrade to neutral may be in the cards at some point next year. Chart I-13Growth Will Underperform Value If Long-Maturity Bond Yields Rise Chart I-14Cyclicals Are Starting To Look Stretched Versus Defensives   Investment Conclusions Next month’s report will feature BCA’s 2022 outlook, as well as a transcript of our recently held annual discussion with Mr. X and his daughter Ms. X (who joined his family office a couple of years ago). Our annual outlook will provide a detailed walkthrough of our views for the upcoming year, as well as answers to sobering questions raised by Mr. X and Ms. X about the longer-term outlook. For now, we recommend that investors stick with a pro-cyclical view, favoring the following assets: Global stocks over bonds A short-duration position within a government bond portfolio Speculative-grade corporate bonds within a credit portfolio Global ex-US stocks vs US, focused on DM ex-US Global value versus growth stocks Cyclicals versus defensives, and small versus large caps Major currencies versus the US dollar Jonathan LaBerge, CFA Vice President The Bank Credit Analyst October 29, 2021 Next Report: November 30, 2021 II. Gauging The Risk Of Stagflation In this report we examine the risk of stagflation by comparing the current environment to that of the late-1960s and 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part due to strong goods demand and supply disruptions that will eventually dissipate, and economic agents do not expect severe price pressures to persist beyond the pandemic. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not a likely event. Investors should use the Misery Index, which is the sum of the unemployment rate and headline PCE inflation, as a real-time stagflation indicator. The Misery Index underscores that the US economy is unlikely to experience true stagflation unless the unemployment rate rises. A portfolio of the US dollar, the Swiss Franc, and industrial commodities may serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-1The Misery Index Reflects The Risk Of Stagflation Over the past several weeks, concerns about a possible return to 1970s-style stagflation have re-emerged significantly in the minds of many investors. These investors have pointed toward similarities between the current environment and that of the 1970s, including shortages limiting output, a snarled global trade and logistical system, and rising energy prices. Chart II-1 highlights that the US “Misery Index” – the sum of the unemployment rate and headline PCE inflation – rose again over the past several months to high single-digit territory, after having fallen dramatically from April 2020 to February of this year. Panel 2 of Chart II-1 highlights that last year's rise in the Misery Index was driven almost entirely by the unemployment rate, whereas the current level is due to a combination of a modestly elevated unemployment rate and a pronounced acceleration in inflation. The headline PCE deflator has risen above 4%, a level that has not been reached since 1991 during the First Gulf War. In this report, we examine the risk of stagflation by comparing the current environment to that of the late 1960s and 1970s. We conclude that while investors cannot rule out the possibility of a stagflationary outcome, there are important differences that point toward a stagflation outcome over the coming 6-24 months as a risk, not a likely event. We conclude by highlighting assets that may produce absolute returns in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Revisiting The 1960s And 70s Chart II-2The 1960s Laid The Groundwork For Elevated Inflation The first step in judging the risk of a return to 1970s-style stagflation is to review, in a detailed way, what caused those conditions. Investors are well aware of the role that two separate energy price shocks played in raising prices and damaging output during this period, but they are less cognizant of the impact that a persistent period of above-trend output and significant labor market tightness had in setting up the conditions for sharply higher inflation. This focus of investors on energy prices partially reflects the fact that the Misery Index increased most visibly in the 1970s and that policymakers in the 1960s may not have realized how extensively economic output was running above its potential. With the benefit of hindsight, Chart II-2 illustrates the extent to which inflationary pressures built up in the 1960s, well before the first oil price shock in 1973. The chart shows that the unemployment rate was below NAIRU – the non-accelerating inflation rate of unemployment – for 70% of the time during the 1960s, and that inflation had already responded to this in the latter half of the decade. Annual headline PCE inflation was running just shy of 5% at the onset of the 1970 recession; it fell to 3% in the aftermath of the recession, but had already begun to reaccelerate in the first half of 1973. Following the 1973/1974 recession, inflation did decelerate significantly, falling from 11-12% to 5% in headline terms, and from 10% to 6% in core terms. But the pace of price appreciation did not fall below 5-6% in the second half of the 1970s, despite a significant and sustained rise in the unemployment rate above its natural rate. The 1975 to 1978 period is especially important for investors to understand, because it is arguably the clearest period of true stagflation in the 1970s. The fact that the Misery Index rose sharply during two major oil price shocks is not particularly surprising in and of itself, given the direct impact of energy prices on headline consumer prices; it is the fact that the index remained so elevated between these shocks, the result of persistently high inflation in the face of significant labor market slack, that is most relevant to investors. There are two reasons that both inflation and unemployment remained high during this period. First, labor market slack was sizeable during these years because the US economy was more energy-intensive in the 1970s than it is today. Chart II-3 highlights that goods-producing employment lagged overall employment growth from late 1973 to late 1977, underscoring that the rise in oil prices significantly impacted jobs growth in energy-intensive industries. Second, it is clear that the combination of demand-pull inflation in the late 1960s and the predominantly cost-push inflation of the 1970s led to expectations of persistent inflation among households and firms. The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. But the experience of the 1970s highlighted that inflation expectations are also an important determinant of inflation, a realization that gave birth to the expectations-augmented (i.e. “modern-day”) Phillips Curve (more on this below). The Stagflation Era Versus Today Table II-1 presents a stagflation “threat matrix,” representing the Bank Credit Analyst service’s assessment of the various factors that could potentially contribute to a stagflationary environment today, relative to what occurred in the 1960s and 1970s. While we acknowledge that there are some similarities today to what occurred five decades ago, the most threatening factors have been present for a shorter period of time and appear to have a smaller magnitude than what occurred during the stagflationary era. In addition, key factors, such as the visibility available to policymakers and investors about household inflation expectations and the potential output of the economy, would appear to reduce significantly the risk of a stagflationary outcome today. We discuss each of the factors presented in Table II-1 below: Fiscal & Monetary Policy Chart II-4Government Spending Last Cycle Looked Nothing Like The 1960s The persistently tight labor market that contributed to the inflationary buildup in the 1960s occurred as a result of easy fiscal and monetary policy. Chart II-4 highlights that the contribution to real GDP growth from government expenditure and investment was very elevated in the 1960s. Chart II-5 shows that a positive output gap in the late 1960s and the first half of the 1970s is well explained by the fact that 10-year US government bond yields were persistently below nominal GDP growth. The relationship between the stance of monetary policy and the output gap only meaningfully diverged in the latter half of the 1970s, during the true stagflationary era that we noted above. Chart II-5Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Chart II-6Monetary Policy Today Is Extremely Easy Today, it is clear that the stance of fiscal policy has recently been extraordinarily easy, and 10-year US government bond yields have remained well below nominal GDP growth for the better part of the last decade. Relative to estimates of potential nominal GDP growth, 10-year Treasury yields are the lowest they have been since the 1970s (Chart II-6). Ostensibly, this supports concerns that policy might contribute to a stagflationary outcome. These concerns were raised by Larry Summers in March, when he described the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.3 But there are two important counterpoints to these concerns. First, easy fiscal policy this cycle has followed a period during the last economic cycle in which government spending contributed to the most sustained drag on economic activity since the 1950s. Unlike the 1960s, the unemployment rate has been below NAIRU for only a third of the time over the past decade. In addition, Chart II-7 highlights that fiscal thrust will turn to fiscal drag next year, underscoring the temporary nature of the massive burst in fiscal spending that has occurred in response to the pandemic. Under normal circumstances, the fiscal drag implied by Chart II-7 would substantially raise the risks of a recession next year, but we have noted in previous reports that a significant amount of excess savings remain to support spending and employment. The net impact of these two factors results in a reasonable expectation that the US economy will return to maximum employment next year, but this is a far cry from the 1960s when the unemployment rate was below its natural rate for 70% of the decade. Based on conventional measures, US monetary policy has been easy for a decade, but easy monetary policy did not begin to contribute positively to a rise in household sector credit growth last cycle until 2014/2015. This underscores that the natural rate of interest (“R-star”) did fall during the early phase of the last economic expansion. However, we argued in an April report that R-star was likely rising in the latter half of the last expansion,4 and we believe that the terminal Fed funds rate is likely higher than what the Fed is currently projecting, barring any additional negative policy shocks. Thus, while we do not believe that the duration of easy monetary policy over the past decade has laid the groundwork for a major rise in prices, it is now clearly positively contributing to aggregate demand and does risk a future overshoot in prices if long maturity bond yields remain well below the pace of economic growth for a sustained period of time. The Impact Of Shortages Chart II-8Gasoline Shortages Plagued The US Economy In The 1970s Gasoline shortages occurred during the oil shocks of the 1970s and are a key similarity that some investors point toward when comparing the situation today with the stagflationary era. Chart II-8 highlights that the annual growth in real personal consumption expenditures on energy goods and services fell into negative territory on six occasions in the 1970s, although it was most pronounced during the two oil price shocks and their resulting recessions. Today, the impact of shortages appears to be broader than what occurred in the 1970s, but less impactful and not likely to be as long-lasting. Chart II-9 highlights that the OPEC oil embargo of 1973 raised the global oil bill by 2.4% of global GDP and permanently raised the price of oil. The global oil bill will only be fractionally above its pre-pandemic level in 2022, with oil prices at $80/bbl, and, while it is true that US gasoline prices have risen significantly, they are not higher than they were from 2011-2014 (Chart II-10). Chart II-9$80/bbl Oil Is Not Onerous Chart II-10US Gasoline Prices Are High, But They Have Been Higher It is certainly true that global shipping costs have skyrocketed and that this is contributing to the increase in US consumer prices. We estimate, however, that this increase in shipping costs as a share of GDP is no more than a quarter of the impact of the 1973 increase in oil prices, without the attendant negative effects on US goods-producing employment that occurred in the 1970s. If anything, surging shipping costs create an incentive to re-shore manufacturing production, which would contribute positively to US goods-producing employment. We also do not expect the rise in shipping costs to be meaningfully permanent, i.e., shipping costs may ultimately settle at a higher level than they were in late-2019, but at a much lower level than what prevails today. Chart II-11A Tight Labor Market Is Causing Wage Growth To Pick Up Semiconductor and labor shortages would appear to represent a more salient threat of stagflation in the US, as the domestic production of motor vehicles cannot occur without key inputs and a tight labor market is already contributing to an acceleration in wage growth (Chart II-11). As we noted in Section 1 of our report, auto production significantly impacted growth in the third quarter. However, Chart II-12 highlights that, for now, the breadth of impact of these shortages appears to be limited: the production component of the ISM manufacturing index remains in expansionary territory, industrial production of durable manufacturing excluding motor vehicles and parts has not broken down, and both housing starts and building permits remain above pre-pandemic levels despite this year’s downtrend in permits. Chart II-12Shortages Do Not Yet Seem To Be Broad-Based A physical shortage of components is a less relevant factor for the services side of the economy, which appears to have re-accelerated meaningfully in October. The services sector is more considerably impacted by shortages in the labor market, which seem to be linked to a still-low labor force participation rate. We noted in our September report that the decline in the participation rate has significantly overshot what would be implied by the ongoing pace of retirements. Chart II-13 highlights that this has occurred not just because of a significant retirement effect, but also because of the shadow labor force (people who want a job but are not currently looking for work) and family responsibilities. We expect that the recent expiry of expanded unemployment insurance benefits, a steady rise in the immunity of the US population, an abating Delta wave of COVID-19, and a likely upcoming reduction in school/classroom closures once the Pfizer/BioNTech vaccine is approved for school-age children will likely ease the labor shortage issue over the coming several months. Output Gap Uncertainty It remains a debate among economists why policymakers maintained such easy monetary policy in the 1960s and 1970s, but Chart II-14 highlights that uncertainty about the size of the output gap may have contributed to too-low interest rates. The chart shows the unemployment rate compared with today's estimate of NAIRU, alongside a simple proxy for policymakers’ real time estimate of the natural rate of employment: the cumulative average unemployment rate in the post-war environment. To the extent that policymakers used past averages of the unemployment rate as their guide for NAIRU, Chart II-14 highlights how they may have underestimated the degree to which output was running above its potential level in the 1960s, and would not have even concluded that output was above potential in the early 1970s. Chart II-14Policymakers Overestimated Labor Market Slack In The 60s And 70s Chart II-15Policymakers Know That NAIRU Is Likely At Or Below 4% Today, the environment is quite different, because the acceleration in wage growth at the tail end of the last expansion gives policymakers and investors a good estimate of where NAIRU is. Chart II-15 highlights that wage growth accelerated in 2018/2019 in response to a sub-4% unemployment rate, which is consistent with both the Fed’s NAIRU estimate of 3.5-4.5% and Fed Vice Chair Richard Clarida’s expressed view that a 3.8% unemployment rate likely constitutes maximum employment (barring any issues with the breadth and inclusivity of the labor market recovery). It is possible that the pandemic has structurally lowered potential output, which could mean that policymakers may no longer rely on the wage growth / unemployment relationship that existed in the latter phase of the last expansion. However, we do not find any credible arguments that would support the notion of a structurally lower level of potential output: the pandemic is likely to end at some point in the not-too-distant future, the negative impact of working-from-home policies on office properties and employment in central business districts is not sizeable,5 and productivity may have permanently increased in some industries because of the likely stickiness of a hybrid work culture. The Behavior Of Inflation Expectations Chart II-16Rising Long-Term Expectations Have Merely Normalized (For Now) One parallel to the argument that policymakers may have underestimated the degree of labor market tightness in the 1960s and early 1970s is the fact that they did not yet understand that inflation expectations are an important determinant of actual inflation, nor were they able to monitor them even if they did. Most credible surveys of inflation expectations began in the 1980s, and policymakers in the 1960s and 1970s were guided by the original Phillips Curve that solely related inflation to unemployment. Today, policymakers have the experience of the stagflationary episode to serve as a warning not to allow inflation expectations to get out of control, and both policymakers and investors have reliable measures of inflation expectations for households and market-participants. Chart II-16 highlights that households expect significant inflation over the coming year, but also expect prices over the longer term to rise at a pace that is almost exactly in line with their average from 2000-2014. The Rudd Controversy: (Adaptive) Inflation Expectations Do Matter One potential criticism of the idea that inflation expectations are signaling a low risk of higher future inflation has emerged through arguments made by Jeremy Rudd, a Federal Reserve economist. In a recent paper, Rudd questioned the view that households’ and firms’ expectations of future inflation are a key determinant of actual inflation; he suggested instead that relatively stable inflation since the mid-1990s might reflect a situation in which inflation simply does not enter workers’ employment decisions and expectations are irrelevant. Rudd’s paper was primarily addressed to policymakers who view inflation dynamics in a highly quantitative light. A full response to the paper would be mostly academic and thus not especially relevant to investors; however, we would like to highlight three points related to the Rudd piece that we feel are important.6 First, we disagree with Rudd’s argument that the trend in inflation has not responded to changes in economic conditions since the mid-1990s. Chart II-17 highlights that while the magnitude of the relationship has shifted, the trend in inflation relative to a measure of long-term expectations based on prior actual inflation has mimicked that of the output gap. The fact that inflation was (ironically) too high during the early phase of the last economic cycle provides some support for Rudd’s inflation responsiveness view, although we would still point toward the Fed’s strong record of maintaining low and stable inflation, its active communication with the public in the years following the global financial crisis, and the fact that a recovery began and the output gap began to (slowly) close as the best explanation for the avoidance of deflation during that period. Second, we agree with Rudd’s point that regime shifts in inflation’s responsiveness to economic conditions can occur, and that adaptive measures of inflation expectations, and even surveys of inflation, may not capture such a shift in real time. Chart II-18 shows that the 2014-2016 period was a good example of this, when adaptive expectations as well as household survey measures of long-term inflation expectations both lagged the actual decline in inflation that was caused by a collapse in the price of oil. Chart II-17The Trend In Inflation Continues To Respond To Economic Conditions Chart II-18Surveyed Inflation Expectations Can Lag, But This Time They Led But Chart II-18 also shows that long-term household survey measures of inflation led the rise in actual inflation (and thus our adaptive expectations measure) last year, underscoring that these measures are likely more reliable indicators today of whether a major regime shift is occurring. As noted above, long-term expectations have risen significantly relative to what prevailed prior to the pandemic, but this has merely raised expectations from extraordinarily depressed levels back to the average that prevailed prior to (and immediately after) the global financial crisis. Therefore, household expectations are not yet at dangerous levels. Chart II-19Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Third, one of the core observations in Rudd’s paper is that unit labor cost (ULC) growth leads the trend in inflation, which he argued was evidence against the idea that expectations of future inflation are a key determinant of actual inflation. Chart II-19 highlights that Rudd is correct that ULC growth modestly leads inflation (especially core inflation), but we disagree with his conclusion that it argues against the importance of expectations. As we noted in Section 2 of our January 2021 Bank Credit Analyst,7 one crucial aspect of the expectations-augmented, or “modern-day” Phillips Curve is that, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. Our view is that ULC growth is fundamentally linked to slack in the labor market, which is directly incorporated in output gap measures. As we noted above, investors currently have a good estimate of the magnitude of the output/employment gap, meaning that it is possible to track the inflationary consequences of prevailing aggregate demand. As a final point about ULC growth, Chart II-19 highlights that while the five-year CAGR of unit labor costs is currently running at its strongest pace since the global financial crisis, investors should note that it remains well below the levels that prevailed in the late-1960s when persistently above-potential output laid the groundwork for a massive inflationary overshoot. Conclusions And Investment Strategy Our review of the 1960s and 1970s highlights that stagflation is a phenomenon in which supply-side shocks raise prices of key inputs to production, which lowers output and raises unemployment. Energy price shocks in the 1970s occurred after a long period of policy-driven above-trend growth in the 1960s, meaning that both demand-pull and cost-push inflation contributed to stagflation in the 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been very expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. Chart II-20It Is Not Stagflation If The Unemployment Rate Continues To Fall However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part the result of strong goods demand and disruptions that are clearly linked to the pandemic (and thus will eventually dissipate), and long-term inflation expectations are behaving differently than short-term expectations, signaling that economic agents do not expect severe price pressures to persist beyond the pandemic. Policymakers also have more visibility about the magnitude of economic / labor market slack than they did during the stagflationary era and better tools to track inflation expectations. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not as a likely event. Using the Misery Index as real-time stagflation indicator, investors should note that the US economy is not likely experiencing true stagflation unless the unemployment rate rises. Chart II-20 highlights that there is no evidence yet of a contraction in goods-producing or service-producing jobs. Even if goods-producing employment slows meaningfully over the coming few months as a result of component shortages, the unemployment rate is still likely to fall if services spending normalizes, as it would imply that the gap in services-producing employment, which is currently 20% of the level of pre-pandemic goods-producing employment, will continue to close. Investors have been focused on the issue of stagflation because its occurrence would imply a sharply negative correlation between stock prices and bond yields. This is not our base case view, but we have highlighted that months with negative returns from both stocks and long-maturity bonds tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). As we discussed in Section 1 of our report, we do expect the Fed to raise interest rates next year. We do not see a rise in bond yields to levels implied by the Fed’s interest rates projections as being seriously threatening to economic activity, corporate earnings growth, or equity multiples. But the adjustment to higher long-maturity bond yields may unnerve equity investors for a time, implying temporary periods of a negative stock price / bond yield correlation. Table II-2 highlights that, since 1980, commodities, the US dollar, and the Swiss franc have typically earned positive returns during non-recessionary months in which stock and long-maturity bond returns are negative. While the dollar is not likely to perform well in a stagflationary scenario, Chart II-21 highlights that CHF-USD and industrial commodities performed quite well in the late-1970s. As such, a portfolio of these three assets might serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-21The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises appear to have peaked, but there is not yet any meaningful sign of waning forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we would continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yield. The US 10-Year Treasury yield remains above its 200-day moving average after failing to break meaningfully below it. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that a move higher over the coming year is likely. However, most of the recent move higher in government bond yields has occurred due to rising inflation expectations, whereas the increase in yields over the coming year will likely occur in real terms. Commodity prices remain elevated, and our composite technical indicator highlights that they are still overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, may weigh on commodity prices at some point over the coming 6-12 months. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see Section 1 of the September 2021 Bank Credit Analyst for a detailed discussion of the US immunity level. 2  Please see US Equity Strategy "Marginally Worse," dated October 11, 2021, available at uses.bcaresearch.com 3  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 4 Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com 5 Please see The Bank Credit Analyst “Work From Home “Stickiness” And The Outlook For Monetary Policy,” dated June 24, 2021, available at bca.bcaresearch.com 6 Rudd, Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?),” Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System. 7  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December 18, 2021, available at bca.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned about the trebling of the crude oil price since March 2020? Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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  

Special Report

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Chart 7Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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