Developed Countries

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Chart 8Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Chart 10The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Chart 12Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Highlights Last month we published a report on the US corporate margins, titled “Marginally Worse.” In the report, we concluded that margins are likely to contract next year, hobbled by a slowdown in top-line growth, falling productivity, a decline in corporate pricing power, and soaring costs of labor and materials. Q3-2021 – another stellar earnings season: Companies achieved superior earnings growth and expanded margins. However, many companies guided down for Q4-2021 and 2022 citing mounting challenges, such as higher costs of labor, shipping, and raw materials. As such, deciphering which sectors are best positioned to maintain profitability is of paramount importance. Framework for Sector Margin Scorecard: We introduce a framework to rank the S&P 500 sector based on the expected resilience of their margins. It is based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. The four factors driving changes in operating margins are: Sell-side operating margins forecasts as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between annualized sales growth in 2020 and 2021 and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Sectors with most resilient margins: According to this scorecard, Financials, Healthcare, Energy, and Utilities are in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Energy Sector - Upgrade to Overweight The medium-term supply/demand backdrop is highly supportive of the current crude oil prices, with a Brent price target of $81 and upside price risk due to inadequate capex. Margins are still below the pre-pandemic peak and the street expects them to increase by 7.74 percentage points over the next 12 months. High operating leverage converts growing demand from the global economic recovery into profitability. Financials – Overweight: O/W Banks, EW Insurance While sell-side analysts anticipate Financials margins will decline, we believe that margins may surprise on the upside: The sector has high operating leverage, is somewhat insulated from supply chain disruptions, sees green shoots in loan growth, and its pricing power is improving. Further, the BCA house view expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting net interest margins. Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector” and upgraded it to Overweight. The Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive in nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months. Further, there is still significant pent-up demand for the health care services, and specifically for the elective procedures – the most lucrative segment of the Healthcare Sector. Pricing power has recently picked up.    Feature Last month we published a report on US corporate profit margins, titled “Marginally Worse.” In that report, we took a close look at corporate margins by analyzing their key drivers. We have concluded that margins are likely to contract next year, driven by a slowdown in top-line growth, falling productivity, and a decline in corporate pricing power. The sales side of the margin equation will fail to offset upward cost pressures imposed by the tight labor market, soaring input prices and transportation costs, rising depreciation expense, and a potential increase in tax rates. We also developed a simple model that encapsulates all the moving parts (Chart 1). Our forecast, based on the model, reiterates that the path of least resistance for US corporate margins is lower. In this report, we will take a close look at the S&P 500 sectors to gauge their ability to grow earnings and preserve margins. We aim to rank them by their ability to maintain profitability. Q3-2021 Earnings Season: Stellar Results Operating sector margins are a focal point for investors in the current environment of soaring shipping costs, PPI readings unseen for the last forty years, and a wage-price spiral that may lead to prolonged periods of elevated inflation. While rising costs have been a concern for a while now, the Q3-2021 earnings season has surprised on the upside, with 81% of companies exceeding analyst earnings expectations. Earnings increased by 42% year-over-year and sales 17%. The two-year annualized growth rate (CAGR) for S&P 500 earnings is 14.6% and 5.7% for sales. The pandemic trough has been all but forgotten, and earnings are back to their trend (Chart 2). All sectors, except for Industrials and Consumer Discretionary, have earnings and sales that exceed pre-pandemic levels (Chart 3). Energy, Materials, and Tech enjoyed annualized eps growth over the past two years in excess of 20%. And of course, because of such robust earnings growth, most sectors have reached 2010 -2021 peak margins (Chart 4). And these are unprecedented high peaks: Most sectors’ margins are more than two standard deviations away from their five-year averages. From a statistical standpoint, Z-scores in this “zip code” indicate that the probability of even higher margins is minuscule (Chart 5). ​​​​​​​ How were companies able to achieve such stellar earnings growth and peak margins despite all the cost and supply chain disruption headwinds? The answer is strong sales growth, efficiency in managing suppliers, ability to pass on costs to customers by raising prices, and finally, high operating leverage. Here is what happened in the words of the companies: Home Depot: “Professional home improvement contractors have had huge backlogs of work to do, and impatient customers have in many cases been willing to pay up in order to get the goods needed despite supply chain problems.” Microsoft: "We do have good understanding of lead times required to meet the capacity and signals that we’re seeing. I think we do a good job managing that. It’s not to say we’re not impacted. Multiple suppliers are important to be able to manage through that, and I feel the team has done a very good job.” Union Pacific Corporation: "The Union Pacific team successfully navigated global supply chain disruptions, a major bridge outage, and additional weather events to produce strong quarterly revenue growth and financial results." Honeywell: "Our disciplined approach to productivity and pricing helped deliver a strong third quarter despite an uncertain global environment marked by supply chain constraints, increasing raw material inflation, and labor market challenges.” Coca-Cola: Our results through the first nine months of 2021," CEO Frank Harrison said, "reflect a strong balance of volume growth, price realization, and prudent expense management." However, there are also multiple cracks in the foundation, with companies such as Target and Amazon guiding lower both for Q4-2021 and 2022 citing higher costs of labor, shipping, and raw materials. As such, deciphering which sectors can maintain profitability is of paramount importance. Building A Sector Margin Scorecard So which sectors have the best ability to preserve or even expand margins over the next year? Forecasting profitability by sector is tricky, as every sector is different, and has disparate drivers of sales and costs, making cross-sectional comparisons challenging. However, we have an advantage – we are not aiming to predict a point estimate for each sector margin a year from now, but rather rank all sectors from best to worst in terms of their ability to maintain profitability. To do so, we have created a scorecard based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. These factors also implicitly incorporate a potential mean reversion, i.e., high readings are unlikely to move even higher. Four factors capturing future changes in the profit margins are: Sell-side forecasts of operating margins over the next 12 months as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between 2019-2021 sales CAGR and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Factor 1: Expected Change In Operating Margins Over The Next 12 Months Top-down sector margin expectations for the next 12 months are an aggregation of the bottom-up company forecasts. Since the stock market is a market of stocks, this is an important summary of companies' trends which we incorporate into our ranking framework. In line with our view, sell-side analysts expect S&P 500 margins to contract by 1.2% over the next 12 months. Margin contraction is expected across the board with two notable exceptions: Energy and Healthcare. In the scorecard, we rank sectors based on the expected magnitude of the margin change, such that sectors with the least compression, or outright growth, are scoring better (Chart 6). Factor 2: Pent-up Demand For The Sector’s Products Most sectors have enjoyed a fantastic sales and earnings recovery this year (Chart 7), with sales exceeding pre-pandemic levels thanks to strong consumer demand. However, to gauge the level of pent-up demand for each sector, we compare 2020-2021 CAGR of sales growth with a long-term sales growth rate. We call this factor “sales growth differential.” Our thinking is that if recent sales growth is below a pre-pandemic normal, there is still demand left on the table. For example, the Consumer Discretionary sector is not yet back to the pre-pandemic “normal” pace of growth. Therefore, there is still strong demand for its products and services. This aligns well with what we were observing for months now. Fears of Covid-19 have resulted in a shift of spending from services to goods. As a result, demand for goods has overshot pre-pandemic levels, while demand for services is below its pre-pandemic trend and is enjoying a rebound (Chart 8). Chart 8There Is Still Pent-up Demand For Services In the scorecard, we assign a higher score to the sectors like Industrials and Consumer Discretionary expecting a more significant pickup in sales growth, and a lower score to the sectors with sales growth that exceeds the historical average on the concern that mean reversion may be in store: A strong bounce back in sales has already materialized, and demand has been pulled forward. Factor 3: Pricing Power Pricing Power is a proprietary BCA indicator based on the PPI and CPI indices for the 60 different industries. Industries are rolled up into sector indices and the market index.1 Sectors with higher pricing power can pass on their costs to their customers. However, at some point, they may no longer be able to raise prices as that will dampen demand for their products. As a result, after a series of price increases, companies’ pricing power wanes. Today, pricing power of companies in most sectors is already two-to-three standard deviations above the five-year average, suggesting that the probability of further gains is extremely low, i.e., one percent or less (Chart 9). The only exceptions are the Healthcare and Financial sectors whose pricing power has barely budged. What sectors do we prefer? Ones with a very high pricing power that is about to roll over or the ones whose pricing power is handicapped by outside political pressures and competitive headwinds? Since we believe that markets are driven by the second derivative, waning pricing power may have a detrimental effect on sector performance, while low and stable pricing power is already priced into expectations. To reflect this thinking, we penalize sectors whose pricing power is high relative to five years of history, expecting mean reversion. Factor 4: Degree Of Operating Leverage The degree of operating leverage (DOL), which gauges the company’s ability to spread its costs over sales, is largely determined by the cost of each marginal unit sold. This is a metric that assesses the cost structure of the sector in terms of fixed costs vs. variable costs. Sectors with higher fixed costs have higher operating leverage: It costs next to nothing to produce a marginal unit of sales, which leads to higher profitability as volume grows. We calculate DOL as the following: DOL= % Change in Operating Income/ % Change in Sales Percentage of change in operating income and sales is a five-year change to smooth out volatility and assess the longer-term relationship. Further, to obtain a comprehensive picture of the longer-term DOL, we calculate a median reading for each sector from 2010 to 2021. Median ignores extreme values and is better at capturing the “normal”. We also exclude negative and zero readings from our calculations to gauge DOL only when the companies are profitable (Chart 10). Bringing It All Together: Operating Margins Sector Scorecard We have ranked all 11 sectors along the four dimensions described above. As a result, we expect Financials, Healthcare, Energy, and Utilities to be in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Energy Sector - Upgrade To An Overweight Energy profit margins are linked to underlying commodity prices. BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate capex. Current operating margins remain well below the previous cyclical peak (Chart 11) and are expected to increase by 7.74 percentage points over the next 12 months. Although the price of oil has risen above the breakeven levels, energy companies are reluctant to invest in capex due to pressure from shareholder activists and newly found financial discipline. As a result, prices are likely to remain high until “high prices cure high prices”. In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yield. Chart 11The Street Expects the Energy Sector Margins To Expand. We concur... Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Upgrade Energy from an Equal Weight to an Overweight Financials – Overweight: O/W Banks, EW Insurance 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. There are early signs that lending is likely to pick up next year (Chart 12). According to JPM: "The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again" Regional banks already see the green shoots. According to Key Bank:"We are pleased with the trajectory of our loan growth." Chart 12Early Signs Of Lending Picking Up  ​​​​​​​Insurance companies are faring worse than Banks. Higher costs of labor and materials result in higher replacement costs, and higher customer payouts. However, insurers succeed in incorporating these higher expenses into pricing. While sell-side analysts anticipate margins will decline, (Chart 13) we believe that they may surprise on the upside: High operating leverage, improving pricing power (Chart 14) and growing demand for loans will contribute to strong profitability. Further, BCA expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting wider net interest margins. Chart 13While The Street Has Doubts About The Financial Sector Margins, We Are Constructive... Chart 14Pricing Power Is Improving Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector.” In this report, we upgraded the Healthcare sector to an overweight. Today, we reiterate the call. First, in a slowdown stage of the business cycle, Healthcare tends to outperform. Second, the Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive by nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months (Chart 15). Further, there is still significant pent-up demand for health care services, and specifically for elective procedures – the most lucrative segment of the Healthcare market. Pricing power has recently picked up (Chart 16). Companies concur that life is getting better: According to JNJ:” many of the hospitals and other providers have to pay more for their input, and that's going to be reflected in the economics as we go forward. And of course, all that is reflected in how we price going forward”. Chart 15The Healthcare Margins Are Posed To Widen Chart 16After A Prolonged Decline, Healthcare Pricing Power Is Finally On The Rise Consumer Staples - Underweight Our sector margins scorecard has identified Consumer Staples as a sector most susceptible to a margin squeeze. Sell-side expects margins to contract by 2% (Chart 17). This is a sector that has low operating leverage which indicates that the marginal cost of producing each additional unit is high, and is particularly vulnerable to rising input costs. At the same time pricing power of the sector is likely to wane: companies were able to raise prices throughout 2021, and now pricing power is over four standard deviations above the five-year average (Chart 18). Raising prices in the environment when fiscal stimulus is in the rearview mirror, against a backdrop of negative real wage growth, will be challenging. Walmart surely knows its customers: It decided to “absorb higher costs and keep prices low for customers all across the business.” Operating Margins of Consumer Staples are likely to contract in 2022. Chart 17Consumer Staples Margins Are Expected To Plunge Chart 18Pricing Power Is Not Sustainable Investment Implications Our analysis indicates that companies in most sectors have reached their peak margins in Q3-2021. Looking ahead, there will be distinct profitability tracks, with some sectors expanding margins while others will experience margin compression. Sectors that have higher operating leverage, pent-up demand left over from the pandemic slowdown, and whose pricing power may still increase will fare best. Our scorecard screened all the 11 sectors based on these conditions, and Financials, Energy, Healthcare, and Utilities have the best shot at maintaining and even expanding their margins. We have been overweight Financials and Healthcare in our portfolios for a while now, and the expectation of resilient profitability only reinforces our conviction. We are upgrading Energy from neutral to an overweight on the back of the expected margin expansion and high oil price target. We are still underweight Utilities which we consider as a bond proxy, unlikely to outperform in a rising rates environment. Bottom Line In this report, we introduce a framework to rank the S&P 500 sectors based on the expected resilience of their margins. Factors we consider are operating leverage, pricing power, pent-up demand, and sell-side margin expectations. As a result of the analysis, we believe that Financials, Energy, Healthcare, and Utilities are posed for strong profitability in 2022.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Appendix: Chart 19 Chart 20 Chart 21 Chart 22 Chart 23 Chart 24 Chart 25 Chart 26 Chart 27 Chart 28 Chart 29 Chart 30 Footnotes 1     Pricing power is calculated by finding the difference between how much the industry has been able to increase prices and the change in the cost of the raw materials due to inflation.  For example, for airlines, pricing power would be measured as the difference in the airfare CPI and jet fuel inflation. The exact calculation is industry specific.  Industries are rolled up into sector indices and the market index.   Recommended Allocation

Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal.  The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong Chart 2More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Chart 4Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 8Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave Chart 11Rate Differentials Hurt The Euro   Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Chart 18Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades   Currency Performance Fixed Income Performance Equity Performance

Special Report

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary