Economy

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Chart 4Liquidity Deterioration At The Margin Chart 5Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Global Inflation: Most central banks, led by the Fed, have stuck to the narrative that surging inflation is a temporary phenomenon that will not require an aggressive monetary policy response. However, global supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will prove to be longer lasting, leading to higher global bond yields. Real Bond Yields: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Feature The month of September has often not been kind to financial markets and September 2021 is already providing many reasons for investors to be nervous. Slowing global growth momentum, uncertainty over the Delta variant, yet another US Debt Ceiling debate in D.C. and worries about excessive Chinese corporate leverage and contagion risks from the looming Evergrande default are all valid reasons for market participants to become more risk averse. On top of that, the monetary policy backdrop is threatening to become less overwhelmingly supportive for markets with the Fed set to begin tapering its asset purchases. Chart of the WeekInflation Expected To Slow But Remain Above Bond Yields One other source of angst that markets seem less concerned about is inflation. Markets have generally come around to the view of most major central banks, led by the Fed, that the surge in inflation seen this year has been all pandemic related - base effect comparisons to 2020 and temporary supply chain squeezes – and will not last into 2022. Yet we have seen very strong realized global inflation readings in the August data, beyond the point of maximum base effect comparisons versus a year ago, while supply squeezes and soaring shipping costs are showing no signs of slowing as we approach the fourth quarter. Global bond markets have made a collective bet that current high rates of inflation will prove to be temporary. Developed market bond yields are all trading well below actual inflation, as are riskier fixed income asset classes like US and European high-yield (Chart of the Week). While consensus expectations are calling for some rise in government bond yields in 2022, yields are expected to remain below inflation. Those persistent negative real yield expectations remain the biggest source of vulnerability for global bond markets. If inflation turns out to be “less transitory” than expected, nominal bond yields will need to move higher to reprice both real yields and the risk of more hawkish central bank responses to sustained high inflation. A Persistent Inflation Threat From Supply Chain Disruptions Chart 2A Broad-Based Surge In Global Inflation Our base-case view remains that global inflation will slow in 2022, but not by enough to prevent the major developed market central banks from tapering asset purchases. We expect the Fed to begin buying fewer bonds in January. Central banks that have already begun to slow the pace of quantitative easing (QE) like the Bank of Canada and Bank of England will likely continue to taper as fast, if not even faster, than the Fed. Even the ECB will likely not roll the full amount of the expiring Pandemic Emergency Purchase Program (PEPP) into the existing pre-COVID asset purchase programs, resulting in a mild form of tapering next year. Our view on global inflation has been predicated on an expected shift away from more externally-driven inflation towards more sustainable domestic price pressures stemming from tightening labor markets and the closing of pandemic output gaps (Chart 2). So the mix of inflation in most developed market countries will be more “core” and less “non-core” inflation driven by higher commodity prices and global supply chain disruptions. Yet there is little sign that those non-core inflation pressures are slowing, particular in price gauges most exposed to supply chains like producer price indices (PPI). US PPI inflation climbed to 15-year high of 8.3% on a year-over-year basis in August, while annual growth in the euro area PPI hit 12.1% in July – the fastest pace in the 30-year history of that data series (Chart 3). Surging PPI inflation reflects global price pressures, with import prices expanding at double-digit rates in both the US and Europe. Some of that more externally driven price pressure stems from commodity markets. While the prices for some notable commodities like lumber and iron ore have seen significant retracements from pandemic-era highs over the past several months, more economically sensitive commodities like aluminum and natural gas have all seen very strong price increases (Chart 4). Copper and oil prices are also holding firm, although both are off 2021 highs. Chart 3No Sign Of Slowing Global Inflation At The Producer Level The price momentum of overall commodity price indices like the CRB Raw Industrials has clearly rolled over, but has held up much better than would be expected given signs of slowing global growth. Chart 4Commodity Markets Still More Inflationary Than Disinflationary The current depressed level of the China credit impulse, and the flat year-over-year change of the global PMI, would typically be associated with flat commodity prices rather than the current 34% annual growth rate (Chart 5). A lack of sustained upward pressure on the US dollar is likely helping keep commodity prices, which are priced in dollars, more elevated than expected. Even more important, however, are the low inventories for many commodities relative to firm demand (which largely explains the current surge in aluminum and natural gas prices). This mirrors a broader global economic trend towards companies running lower inventories relative to sales, which has been exacerbated by the economic uncertainties of the COVID-19 pandemic. The US overall business inventory-to-sales ratio is now at the lowest level in the history of the series (Chart 6). Chart 5Commodity Price Inflation Peaking, But Not Slowing Much Chart 6Supply Squeezes Are Likely To Persist Before the pandemic, firms have gotten away with running very lean inventories because of globalized supply chains that allow firms to maintain the minimum amount of inventory to meet demand. Yet “just-in-time” inventory management only works when suppliers can deliver raw materials or finished goods in a timely fashion at low cost. The pandemic has blown up that model, making it much harder to deliver products and materials from critical countries like China. Global shipping costs have exploded higher and are showing no signs of slowing (bottom panel), while supplier delivery times remain well above historical averages according to measures like the US ISM index. Those higher costs are feeding through into overall inflation measures, particularly for the components most exposed to supply chain disruption. In Chart 7, we show a breakdown of the overall CPI inflation data for the US, euro area, UK and Canada. The groupings shown in the chart are based on an analysis done by the Bank of Canada back in August to measure pandemic impacts on Canadian inflation.1 The top panel of the chart shows the contribution to overall inflation for elements most exposed to supply constraints (like autos and durable goods). The second panel of the chart shows the contribution from sectors more exposed to increased demand as economies reopen from pandemic restrictions, like dining at restaurants and travel. The remaining panels of the chart show the contributions from energy prices and all other components not covered in the top three panels. Chart 7Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Chart 8High US Inflation May Not Prove To Be So Transitory The conclusion from our chart is that supply disruptions have added more to US and Canadian inflation so far in 2021, while reopening demand has been more meaningful for UK and US inflation. The pickup in euro area inflation has been mostly an energy price story, although reopening demand has started to contribute to the rising trend of overall inflation. The implication from this analysis is that persistent supply chain disruptions could become a bigger issue for future inflation – and monetary policy decisions – in the US and Canada. The acceleration of US realized inflation in 2021 has already begun to broaden out from the most volatile components, according to measures like the Dallas Fed Trimmed Mean PCE (Chart 8). Faster inflation is also feeding through into higher US consumer inflation expectations according to surveys from the New York Fed and the University of Michigan. Those increases are not deemed to be temporary, with longer-term inflation expectations now moving higher. The New York Fed’s survey shows that inflation is expected to be 4% over the next three years, two full percentage points above the Fed’s target, which must be ringing some alarm bells on the FOMC. Chart 9European Consumers Are Waking Up To Higher Inflation Consumer inflation expectations are also starting to perk up outside the US. The YouGov/Citigroup survey shows an expectation of UK inflation over the next 5-10 years of 3.5%, while the Bank of England/Kantar survey is at 3% over the next five years (Chart 9, top panel). Both are above the Bank of England’s 2% inflation target. The European Commission confidence surveys have shown a sharp increase in the net share of respondents expecting higher inflation in the coming months (bottom panel), while the Bundesbank’s August consumer survey shows that Germans now expect 3.5% inflation over the next 12 months, up from 2% back in March. Bottom Line: Supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will last much longer than expected and force a bond-bearish repricing of future interest rate expectations. Negative Real Yields – The Achilles Heel For Bond Markets It is clear that supply chain disruptions are having a more lasting effect on global inflation than investors, and policymakers, expected earlier this year. Yet while both market-based and survey-based measures of inflation expectations are moving higher, interest rate markets are still pricing in a very dovish future path for policy rates of the major developed market central banks. For example, our 24-month discounters, which measure the change in interest rates over the next two years discounted in overnight index swap (OIS) curves, show that only 71bps, 61bps and 13bps of rate hikes are expected in the US, UK and euro area, respectively, by September 2023 (Chart 10). This continues a trend that we have highlighted in recent reports – the persistence of negative real interest rate expectations in the developed markets that is also keeping real bond yields in sub-0% territory. In the US, the OIS forward curve shows that the first Fed rate hike is expected in early 2023 with a very slow pace of rate increases over the following 2-3 years (Chart 11). The funds rate is expected to level off at 1.75% and stay there through 2030. At the same time, the CPI swap forward curve has inflation falling steadily over the next couple of years, but leveling off around 2.35% for the rest of the upcoming decade. Combining those two forward projections comes up with an implied path for the real fed funds rate that is persistently negative for the next ten years, “settling” at -0.6% by the end of the decade. Chart 10Bond Markets Exposed To More Hawkish Central Banks Chart 11US Real Yields Priced For Extended Fed Dovishness An even more deeply negative real rate path is discounted in the euro area forward curves. The ECB is expected to begin lifting rates in 2023, eventually moving out of negative (nominal) territory in 2026 before climbing to +0.5% by 2030 (Chart 12). Euro area CPI swaps are priced for a fall in inflation back below 2% over the next two years, eventually stabilizing at 1.75% over the latter half of the next decade. The real ECB policy rate is therefore expected to settle at -1.25% by 2030. In the UK, markets are discounting much of what has been seen in the years since the 2008 financial crisis – a Bank of England that does very little with interest rates. The central bank is expected to begin lifting rates in 2023, but only a handful of rate hikes are expected in the following years with Bank Rate only climbing to 1% and settling there for most of the upcoming decade. The UK CPI swap curve is discounting relatively high inflation over the next decade, settling at 3.6% in 2030. Thus, the market is discounting a long-run real Bank of England policy rate of -2.6%. This pricing of negative real policy rates so far into the future goes a long way to explain why longer-term real government bond yields have also been consistently negative in the US, Germany, UK and elsewhere in the developed markets. That can be seen in Charts 11, 12 and 13, where we have added the 10-year inflation-linked (real) bond yield for US TIPS, French OATis and UK index-linked Gilts. In all three cases, the 10-year real yield has “gravitated” towards the realized path of the real policy rate – the nominal rate minus headline CPI inflation – over the past two decades. Chart 12Negative Real Rates Forever In Europe? Chart 13BoE Not Expected To Do Much Over The Next Decade Chart 14Nominal Yields Will Move Higher If Negative Real Yields Persist Persistent low government bond yields, both in nominal and inflation-adjusted terms, have resulted in lower yields across the global fixed income markets as investors have been forced to take on more risk to find acceptable yields. This has resulted in a situation where nominal yields on riskier assets like US high-yield corporate bonds and Italian government debt are trading below prevailing headline inflation rates in the US and Europe (Chart 14). Bond investors would likely only be comfortable accepting such negative real yields on the riskier parts of the fixed income universe if a) inflation was expected to decline, and/or b) real yields on risk-free government bonds were expected to stay negative for longer as central banks stay dovish. In either case, the “bet” made by investors is that the inflation surge seen this year will indeed prove to be transitory, as central banks are forecasting. If that benign outlook proves to be incorrect and inflation stays resilient for longer – potentially because of the risk of lingering supply chain disruptions described earlier in this report - nominal bond yields will have to reprice higher to account for faster realized inflation (and, most likely, rising inflation expectations). This process will start in government bond markets, as global central banks will be forced to respond to stubbornly high inflation by turning more hawkish, first with faster tapering of QE bond buying and, later, with interest rate hikes. We continue to see persistent negative real yields as the biggest source of risk in developed economy bond markets over the next couple of years. Those yields discount a benign path for both inflation and future monetary policy that is looking increasingly less likely – especially with tightening labor markets and rising consumer inflation expectations already forcing central banks, led by the Fed, to move incrementally towards less accommodative policy settings. Bottom Line: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Stay below-benchmark on overall global duration exposure in fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have attempted to match the groupings shown in the Bank of Canada analysis as much as possible for the other countries, although there are some minor differences based on how each country’s consumer price index sub-indices are defined. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Chart 2Natgas Storage Remains Tight US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 Chart 6       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades