Developed Countries

Next week we will be holding our quarterly webcast discussing the US equity market outlook. As a brief prologue to the webcast, the following Insight report provides a summary of our recent moves and views. In our latest Strategy Report we posited a cautious outlook for the US margins into the year end. While margins are likely to contract, we don’t expect a bear market in equities. Instead, equities are likely to print pedestrian single digit returns on the back of high valuations, and multiple expansion that “borrowed” returns from the future over the course of 2020. However, the TINA theme is still at play and excess liquidity will hold off a bear market. Even if top line S&P 500 returns remain paltry, money can still be made by granular sector selection and rotation (see chart). Specifically, we recently went overweight Small Caps at the expense of Large Caps as this asset class tends to outperform in a rising rates environment. Bottom Line: While S&P 500 returns are likely to remain in single digits over the coming months, there are plenty of opportunities on the sector level.  

Highlights UK GDP is on track to overtake pre-pandemic levels. This will strengthen the case for the BoE to tighten monetary policy. That said, markets are aggressively pricing in a hawkish BoE. This creates room for near-term disappointment. The post-Brexit environment still remains volatile, especially vis-à-vis Northern Ireland. This opens a window to tactically go long EUR/GBP. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.45 over the next 12 months. Feature Chart I-1A Robust Recovery In UK Growth The UK recovery has been progressing smartly (Chart I-1). GDP growth is on track to increase by 7.25% this year, and 6% next year, according to the Bank of England (BoE). This is well above potential, and will eclipse growth in other developed economies. Markets have reacted accordingly. The pound is marginally higher versus the dollar this year, despite broad-based USD strength. Gilt yields have risen versus most developed market long rates. The OIS curve is already discounting at least 3 rate hikes by the BoE next year, much higher than most other developed market central banks (Chart I-2). The risk is that it creates downside risks for sterling in the near-term, even if the longer-term outlook remains bullish. Chart I-2A Violent Repricing In Interest Rate Expectations Robust Domestic Conditions Most measures of domestic demand in the UK remain robust. The employment rate is higher than in the US, with unemployment fast approaching NAIRU (Chart I-3). Projections from the BoE no longer forecast an acute impact from the expiration of the furlough scheme. Unemployment should hit 4.25% in 2022, pinning it close to the lows of the last several decades. Chart I-3The UK Versus US Jobs Recovery An Employment Boom Robust labor market conditions are beginning to shift bargaining power to workers. Vacancy rates are closing in on fresh highs relative to unemployed workers and wages have inflected noticeably higher (Chart I-4). The BoE has noted that compositional effects could have exarcerbated the pace of wage increases, with most job losses aggregated in sectors with lower pay. As the economy progresses towards full employment, wage growth will moderate from current levels, but will still be very robust by historical standards. Inflation has been the wild card in the UK. The headline inflation print is currently 3.2%, while core CPI sits at 3.1%, well above the MPC’s 2% target. Meanwhile, the 10-year CPI swap rate has shot up to 4.2%, brewing expectations that higher inflation could become entrenched (Chart I-5). This has pushed up bets that the central bank could turn even more hawkish. Chart I-4Employees Are Gaining Bargaining Power Chart I-5Will UK Inflation Be Transitory? From a big picture perspective, the acute increase in money supply growth stemming from aggressive easing by the BoE has stimulated economic activity. As such, the velocity of money is rising sharply in the UK (Chart I-6). To prevent a potential overheating of the economy, the BoE will need to raise rates. This is bullish for cable. Finally, house price inflation in the UK remains robust. While this has been a global phenomenon, surveys suggest that the pace of house price increases will accelerate in the coming months (Chart I-7). With the most negative interest rates in the G10, this will be cause for concern for the BoE Chart I-6Money Velocity In The UK Chart I-7Will The Housing Boom Be Sustained? The Policy Response Chart I-8The BoE Will Withdraw Emergency Monetary Settings On the monetary policy front, the BoE is acting accordingly. Asset purchases are slated to end soon, with the central bank having bought £869bn of its £895bn target (Chart I-8). In fact, two members of the MPC voted at the last policy meeting to reduce this target by £35bn, which would have effectively ended QE. Meanwhile, markets are priced for at least three interest rate hikes over the next 12 months. We agree that tighter monetary policy is warranted over the longer term. However, our bias is that market expectations for interest rate increases may have overshot, a potential setup for disappointment in the very near term. Offsetting Factors Inflation in the UK could prove transitory, and fall much faster than the market expects. According to BoE forecasts, inflation should settle closer to 2% by the end of next year. Yet the market is still pricing in very sticky inflation in the UK. The 5-year inflation swap currently sits at 4.4%, while the 10-year sits at 4.2%. These are very high numbers which are susceptible to downside surprises in the coming months. A firm trade-weighted pound will be the first catalyst for lower inflation. Historically, a strong GBP has dampened inflationary pressures through lower input costs (Chart I-9). It is remarkable that there has been a strong divergence between the currency and inflation expectations in the current regime. This can be partly attributed to a pandemic-related surge in restaurant and hotel costs, high transportation costs, and a surge in housing utilities, all amidst an electricity shortage (Chart I-10). Global supply chains are also under siege. Chart I-9The Inflation Overshoot Will Not Persist Chart I-10Transport And Utility Inflation Could Prove Transitory However, energy costs in Europe could modestly subside in the coming months. The opening of the Nord Stream 2 pipeline, connecting Russia with Europe, will help alleviate the euro zone energy crisis. For the UK in particular, the opening of the 1,400 MW undersea cable with Norway this month should assuage the electricity shortage. The pace of house price appreciation may also temper going forward. The UK holiday stamp duty, introduced in July 2020, expired last month. Under the scheme, taxes paid on property purchases were exempt to a ceiling of initially £500,000 until March 2021, and eventually £250,000. Housing in the UK has been supported by low interest rates and higher savings, factors pushing up global real estate demand, but the pickup in housing transactions ahead of the expiry of the rebate should ebb.  The post-Brexit environment also remains volatile, especially vis-à-vis Northern Ireland. Significant checks exists on goods from the UK to Northern Ireland, even if they are slated for final consumption. This is leading to delays, and hampering UK businesses. The UK has been pushing back strongly against this, asking for an adjustment to the Brexit agreement. So far, the UK trade balance with the EU has been recovering, but overall, balance of payments dynamics remain a negative (Chart I-11). As we go to press, Europe’s Brexit negotiator, Maros Sefcovic, is being pressed by member states to draw up retaliatory measures, should the UK default on its agreement. Chart I-11The UK Trade Balance With The EU Is At Risk Finally, the pound is also being held hostage to global macro dynamics. The UK runs a basic balance deficit. This means portfolio inflows, both in equities and bonds are needed to finance the trade deficit. These portfolio flows accelerated this year, but are now relapsing (Chart I-12). The risk is that a correction in global equity markets could exarcebate this trend (Chart I-13). Chart I-12Portfolio Flows Into The UK Have ##br##Slowed Chart I-13The Pound Is Susceptible To A Market Correction   Trading Opportunities The pound is likely to fare well over a cyclical horizon. Our 12-month target is 1.45 with a best-case scenario above 1.50. This target is based on mean reversion towards fair value. On a real effective exchange rate basis, the pound is about 15% below the mean. This is lower than where it was after the UK exited the Exchange Rate Mechanism in 1992 (Chart I-14). Over time, the pound will converge towards the mid-point of this historical range, pushing it near 1.50. Our in-house PPP models suggest the pound is undervalued by 12%. Our models on average revert to the mean over three years, suggesting the pound could revert to fair value in the next 12-to-18 months (Chart I-15).1  Our intermediate-term timing model suggests the pound is 0.5 standard deviations below fair value, and will also gravitate towards 1.50 over the next year or two. This model incorporates risk variables such as corporate spreads and commodity prices that drive fluctuations in the pound (Chart I-16). Chart I-14The Trade-Weighted Pound Is Cheap Chart I-15GBP/USD Is Cheap On A PPP Basis Chart I-16GBP/USD Is Cheap On A Competitive Basis However, in the near term, the pound could relapse versus other G10 currencies. EUR/GBP: Interest rate expectations are bombed out in the euro area, relative to the UK. This is occurring at a time when PMI data remain relatively upbeat in the eurozone (though rolling over, Chart I-17). A modest reset in relative rate expectations could ignite EUR/GBP. We are initiating a long position at 0.846, with a stop loss at 0.835. GBP/JPY: The pound has rallied hard against the yen this year. Yet, real interest rates in the UK have cratered relative to Japan, as inflation has overshot in the former. The trade balance with Japan is also deteriorating, one year after a free-trade agreement was signed (Chart I-18). This divergence cannot last as relative trade surpluses/deficits have driven the exchange rate over the last three decades. We expect the yen to modestly outperform the pound in the next 3-to-6 months. AUD/GBP: The Aussie should outperform the pound. First, the cross has tremendously lagged levels implied by relative terms of trade. Even if commodity prices relapse, the margin of safety will remain very wide. Second, investors are massively short the Aussie relative to cable. From a contrarian perspective, this will pull AUD/GBP higher (Chart I-19). Chart I-17Buy EUR/GBP For A Trade Chart I-18GBP/JPY Is Vulnerable In The Short Term Chart I-19AUD/GBP Still Has Upside Overall, sentiment on the pound remains ebullient, and our intermediate-term technical indicator has yet to hit capitulation lows (Chart I-20). This is modestly negative in the short term. That said, should the dollar experience broad-based weakness, as we expect, the pound might underperform the crosses, but will fare well against the dollar. Chart I-20Cable Will Hit Capitulation Lows Soon   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Strategy Report, "Updating Our PPP Models," dated November 13, 2020. Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

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 surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Dear client, Next week, instead of sending you a Strategy Report, we will be hosting our quarterly webcast “Taper Tantrum 2.0” on Monday, October 18 at 10 am EDT and 9 pm EDT, addressing the recent market moves and discussing the US equity market outlook. Kind Regards, Irene Tunkel   Only time will tell how long the current energy crisis and the resulting bull market in energy equities will last, but a violent snapback is in the cards for crude oil once supply challenges dissipate. Crude oil and the US dollar have historically enjoyed a tight negative correlation (oil, like other commodities, is priced in USD). This relationship has broken down only five times since 2004, with the latest occurrence unraveling right now (see chart, the US dollar shown on an inverted scale). Each break down in the correlation was followed by a correction in energy prices in excess of more than 20% on average. The resolution of the crisis is likely to follow a familiar pattern: Shale producers will ramp up capex spending and drill more wells, which are profitable at the current price level. It is also unlikely that the divergence will close with a downward move in the US dollar, given the Fed’s imminent tapering and rising Treasury rates. Given the explosive spike in energy prices and lack of visibility as to when the crisis will be resolved, we have recently downgraded the S&P energy index from overweight to neutral. Bottom Line: The longer the crisis lasts, the more violent the snapback in WTI and energy equities will be. ​​​​​​​ ​​​​​​​

Highlights As US inflation proves to be not-so-transitory, US interest rate expectations will rise. Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. The net impact from China’s slowdown and higher US interest rate expectations on mainstream EM will be currency depreciation. Rising mainstream EM nominal and real (inflation-adjusted) interest rates do not often lead to domestic currency appreciation A strengthening dollar vis-à-vis EM currencies is bad news for EM fixed-income markets – both local currency bonds and credit markets. Feature This report discusses EM local currency (domestic) bonds and US dollar bonds (credit markets). To begin with, we reiterate our main macro themes since January this year: (1) a slowdown in China and (2) rising US inflationary pressures and higher US bond yields. These macro themes will create tailwinds for the US dollar, at least for the next several months. A strengthening dollar is bad news for EM fixed-income markets. China’s Slowdown China’s slowdown will continue to unfold. China’s credit (TSF1 excluding equity) growth has slowed further in September (Chart 1, top panel). Similarly, household mortgages are also decelerating sharply (Chart 1, bottom panel). Chart 1China's Money And Credit Are Decelerating Chart 2Curtailed Financing For Property Developers = Less Construction Activity     China's ever-important property market and construction activity will contract in the months ahead. Property sales were down by 20% in September from a year ago. Property developers in recent years have been relying on pre-construction sales as a major source of financing. With pre-sales drying up and borrowing restrained by both government regulations and creditors’ unwillingness to lend, property developers will be unable to sustain the current pace of construction and completion (Chart 2). Chart 3Red Flags For EM ex-TMT Stocks For the same reason, property developers have curtailed their purchases of land. Land sales have been a major source of local government revenues – it is estimated to account for 45% of local government revenues including managed (off-balance sheet) funds. The upshot will be that local governments will be unable to ramp up their infrastructure spending to offset shrinking property construction. Altogether, these will have negative implications for the mainland’s industrial economy and raw materials. Notably, global material stocks have rolled over decisively even though CRB Raw Materials price index has yet to peak (Chart 3, top panel). Global industrial stocks in general and machinery stocks in particular have also relapsed. Finally, Chinese non-TMT share prices have dropped by 20% from their February high and EM ex-TMT equity prices have formed a head-and-shoulder pattern, which often precedes a major gap down (Chart 3, bottom panel). These equity market signals are foreshadowing a slowdown in China’s “old economy”. Bottom Line: The shockwaves emanating from the slowdown in China will hinder growth in Asia and commodity-producing economies in the rest of EM. This is positive for the US dollar because among major economic blocks, the US economy is the least exposed to the mainland economy. US Interest Rates Will Be Repriced US bond yields will continue marching higher, supporting the US dollar. The reasons for higher bond yields are as follows: Investors and commentators can differ on their assessment of the US inflation outlook. However, one thing that we should all agree on is that uncertainty over the US inflation outlook is extraordinarily high. Heightened uncertainty requires a higher risk premium in bonds, i.e., a wider bond term premium. Surprisingly, until August, the term premium on US bonds was very subdued (Chart 4). In brief, the US bond term premium will rise to reflect uncertainty around the inflation outlook, which will push bond yields higher. US wages hold the key to the inflation outlook. We believe that wage growth will surprise to the upside as many companies have strong order books but are struggling to hire. As people gradually return to the labor force, employers have a once in a decade chance to attract qualified employees. Hence, companies will likely compete with one another by offering higher wages to attract the most qualified candidates. The job quit rate is the highest it has been since the early 2000s. This rate also points to higher wages (Chart 5). Chart 4High Inflation Uncertainty Heralds Higher Bond Term Premium And Yields Chart 5US Wage Growth Will Accelerate   Three factors that had suppressed US bond yields will likely be reversing: US commercial banks have been major buyers of US Treasurys and agency securities; the US Treasury has depleted its account at the Fed due to the debt ceiling but will now begin issuing more bonds to fill in this account; the Fed has been purchasing $80 billion of US government bonds each month; however, the Fed is preparing to taper and therefore reduce these purchases. Chart 6US Banks Have Been Buying Bonds En Masse US commercial banks’ holdings of US government and agency securities has risen to 19% of their total assets – on par with their early 1990s all-time high (Chart 6, top panel). In turn, the share of loans and leases has fallen to an all-time low (Chart 6, middle panel). As US banks begin to expand their lending, they will likely reduce the pace of their buying of US Treasurys. This along with the US Treasury issuing more paper to increase its depleted Treasury General Account at the Fed (Chart 6, bottom panel) and the Fed’s tapering will likely push up US bond yields. Current shortages are the result of excessive demand, rather than producers operating below capacity.2 The fact is that the supply/shipment of goods is booming, at least from Asia/China to the US. This will prove to be inflationary, and therefore lead to higher bond yields. Chinese shipments to the US continue to thrive – in September, export values were up by 30.5% from a year ago (Chart 7, top panel). Given that US import prices from China are rising at an annual rate of 3.8%, China’s export volume to the US has grown to about 26.7% from last September when it was already booming. Consistently, inbound containers unloaded at the Long Beach and LA ports have surged to all-time highs (Chart 7, bottom panel). Hence, US ports are not operating below capacity, it is excessive demand for goods that has created these bottlenecks. Finally, concerning semiconductors, shortages are due to excessive demand not a failure to produce. Global semiconductor production has been growing rapidly over the past two years. A silver lining is that a capitalistic system will eventually expand production and meet demand. Although we broadly agree with this expectation, it will take a couple of years for this to take place. In the interim, we can expect to see higher prices, at least for goods, and rising inflation expectations. Bottom Line: As US inflation proves to be not-so-transitory, US interest rate expectations will rise, which will support the US dollar. The broad-trade weighted US dollar has been correlated with US TIPS yields (Chart 8). Chart 7Shipments From Asia To The US Have Been Booming Chart 8High US Rates Will Support The Dollar   EM Domestic Bonds Chart 9EM Inflation Has Been Spiking EM domestic bond yields have been rising as inflation in EM ex-China, Korea, Taiwan (herein referred as mainstream EM) has been surging (Chart 9). Even if commodity prices roll over, EM interest rate expectations will likely continue rising for now because of higher US bond yields and EM currency weakness. Many clients have been asking whether rising mainstream EM policy rates and local bond yields will support EM currencies. We do not think so. In high-yielding interest rate markets such as Brazil, Mexico, South Africa, Russia and Turkey, neither short- nor long-term rates have been positively correlated with the value of their currencies (Chart 10 and 11). Chart 10Higher Bond Yields Do Not Lead To Currency Appreciation In Brazil And Mexico Chart 11Higher Bond Yields Do Not Lead To Currency Appreciation In Russia And South Africa Chart 12Higher EM Inflation-Adjusted Bond Yields Do Not Lead To EM Currency Appreciation Further, in these markets real (inflation-adjusted) rates also have not been positively correlated with their currencies (Chart 12). As illustrated in Charts 11, 12 and 13, there has been no positive correlation between both EM nominal and real (inflation-adjusted) interest rates and their currencies. Rather, there has often been a negative correlation. The basis is that exchange rates drive interest rate expectations, not vice versa. Currency depreciation leads to higher inflation expectations and rising interest rates. Conversely, exchange rate appreciation dampens inflation expectations paving the way for declining interest rates. Bottom Line: The net impact China’s slowdown and higher US interest rate expectations on mainstream EM domestic bonds will be currency depreciation with little room for their central banks to cut rates. As a result, local bonds’ risk-reward factor remains an unattractive tradeoff. EM Credit Markets As we laid out in A Primer on EM USD Bonds report  on April 29, EM exchange rates and their business cycle are the key drivers of EM sovereign and corporate credit spreads. If EM currencies drop, EM sovereign and corporate credit spreads will widen (Chart 13). The basis is that foreign currency debt servicing will become more expensive as EM currencies depreciate. As EM growth disappoints, EM credit spreads will widen too (Chart 14). Chart 13EM Credit Spreads And EM Currencies Chart 14EM Profit Expectations And EM Corporate Spreads   In addition, the continuous carnage in Chinese offshore corporate bonds will heighten odds of a material selloff in this EM credit. Chinese property companies’ USD bonds make up a more than half of China’s offshore USD corporate bond index and a large part of the EM corporate bond index. Poor performance of the EM corporate bond index could trigger outflows from this asset class. Investment Recommendations Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. As the interest rate differential between China and the US narrows, the CNY will likely experience a modest setback versus the greenback (Chart 15). Even small RMB weakness could produce a non-trivial depreciation in EM exchange rates. The latter is negative for EM local currency bonds and EM credit markets. Absolute-return investors should stay on the sidelines of EM domestic bonds. For dedicated investors in this asset class, our recommended overweights are Mexico, Russia, Korea, India, China, Korea, Malaysia and Chile. EM credit markets will continue to underperform their US counterparts (Chart 16). Credit investors should continue underweighting EM credit versus their US counterparts, a strategy we have been recommending since March 25, 2021. Chart 15CNY/USD And The Interest Rate Differential Chart 16EM Credit Markets Are Underperforming Their US Peers   Finally, EM ex-TMT share prices correlate with inverted EM USD corporate bond yields (Chart 17). Higher EM corporate bond yields (shown inverted in Chart 17) entail lower EM ex-TMT share prices. Chart 17High EM USD Bond Yields Herald Lower Share Prices In turn, China’s TMT stocks remain vulnerable as we have argued in past reports. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Total Social Financing. 2 We made a similar case for Chinese electricity shortages in last week’s report. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations