Commodities & Energy Sector

Highlights The faster-than-expected oil-demand recovery from the COVID-19 omicron variant points to higher EM trade volumes this year and next, which, along with a weaker USD, will boost base-metals demand and prices (Chart of the Week). The recovery in iron-ore prices on the back of China stimulus and omicron-induced labor shortages at miners will lift copper prices, the base-metals' bellwether.  Supply-demand balances in refined copper showed a physical deficit of 438K MT for the January-October 2021 period, indicating the market extended its years-long deficit in 2021. Despite the IMF's mark-down in global growth due to slowdowns in the US and China this year, metals demand will continue to exceed supply, which will support prices. Short squeezes – most recently in nickel, following a headline-grabbing copper squeeze in October – will keep base metals' inventories under pressure and forward curves backwardated. We remain long the S&P GSCI and the COMT ETF, as well as the PICK ETF, to remain exposed to backwardation.  At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off. We are raising our 2022 copper target to $5.00/lb on COMEX, and keeping our 2023 expectation at $6.00/lb. Feature Inadequate development in new base metals supply, which has been apparent for years, means economic recovery and expansion will continue to tax existing supplies over the short run (to end-2023).1  Chart of the WeekExpected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Chart 2Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... At a global level, prolonged supply-demand imbalances mean inventories will continue to be drawn hard to cover for prompt supply shortfalls.  This can be seen in the principal base metals we cover: copper (Chart 2), aluminum (Chart 3), nickel (Chart 4), and zinc (Chart 5).  As a result, short squeezes in base metals markets will continue to grab headlines, as persistent physical deficits periodically drain inventories.2   Longer term, the global effort to decarbonize energy supply could be stretched out well beyond 2050, when most policymakers assume the task of replacing fossil-fuel energy sources will largely be completed.  The longer it takes to mobilize capex, the more expensive the energy transition becomes, as markets are continually forced to adjust to short-term shortages leading to price spikes and squeezes in an effort to meet demand. Chart 3...Aluminum... ...Aluminum... ...Aluminum... Chart 4...Nickel... ...Nickel... ...Nickel... Chart 5...And Zinc. ...And Zinc. ...And Zinc. Faster Demand Recovery In Metals Faster-than-expected oil-demand recovery will translate to higher trade volumes globally this year and next.  This is particularly important for EM markets, given oil and metals prices – particularly copper, the base metals bellwether – share a common long-term equilibrium (i.e., they're cointegrated, as seen in the Chart of the Week).3 A pick-up in EM trade volumes, along with a weakening USD this year, will help lift copper prices.  Most trade is in manufactured goods, which will translate into a pick-up in cyclical stocks vs. defensive stocks as well, which also is supportive of copper prices (Chart 6). Copper prices also will be supported by the recovery in iron-ore prices, which have been bid up on the back of increasing stimulus in China and global growth ex-China, as well as omicron-induced labor shortages among miners.  As is typical, copper demand will follow in the wake of steel demand, as construction and infrastructure projects are finished off (i.e., plumbing and wiring are installed) (Chart 7). Chart 6Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Chart 7Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Supply Side Remains Challenged Impressive gains put up on the supply side last year in Indonesia – which, according to the International Copper Study Group, posted a 51% increase in copper output at the Grasberg mine over the first 10 months of 2021, – and other smaller producers notwithstanding, geopolitical uncertainty continues to dominate the supply-side risks to base metals generally, copper in particular.4 Economic and political uncertainty in Chile and Peru, which account for 30% and 10% of global copper output, respectively, will continue to keep miners hesitant in their capex allocations, in our view.  Both states have elected left-of-center governments, which still are working through how they will deliver on their election mandates, including revenue re-distribution, taxation and royalties.5 The combination of stronger demand and tepid supply growth will keep base metals inventories under pressure, which will translate into continued backwardation.  This is particularly apparent in the copper (Chart 8) and nickel (Chart 9).  Both of these squeezes resulted from buyers treating the London Metal Exchange as a supplier of last resort – which is an extremely rare occurrence in futures markets – and both required the intervention of the London Metal Exchange to address.6 Chart 8Copper Backwardation Will Persist Copper Backwardation Will Persist Copper Backwardation Will Persist Chart 9...As Will Nickels ...As Will Nickels ...As Will Nickels Investment Implications Base metals markets will continue to find it difficult to match supply with demand, as they have for the past several years.  This further compounds the global energy transition – largely because the suppliers of the metals needed to pull it off are starting from a deep physical deficit position – and likely delays it considerably. In an environment in which obstacles to developing the supply needed to phase out fossil fuels in favor of renewable generation continue to mount, we remain long commodity index exposure – the S&P GSCI and COMT ETF – and favor exposure to miners and trading companies that are responsible for moving metals around the globe. At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off of 10% for its highs of $47/share.  Our view on base metals is they are a long-term value play, in which miners and the supply side generally, will benefit from the high prices needed to develop the supply the energy transition will require.  The big risk here is these companies once again lose the plot and fail to control costs to produce at the expense of the health of their margins.  If we see this, we will exit the position.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish We expect OPEC 2.0 to announce they'll continue with the return of another 400k b/d at next week's monthly meeting.  In reality, the producer coalition most likely will fail to return these volumes to market and will fall short of the mark again.  The real news markets are waiting for is whether the four states capable of increasing supply and sustaining higher output – Saudi Arabia, Iraq, the UAE and Kuwait – will step up to cover the growing gap between volumes that were pledged and what's actually been delivered.  The coalition agreed in July 2021 to begin returning some of the 5.8mm b/d of output pulled from the market during the COVID-19 pandemic starting in August 2021.  To date, the producer group has fallen short by about 800k b/d, based on the IEA's January 2022 estimates. Failure to increase production by the four core OPEC 2.0 states could keep prices above $90/bbl this year and next (Chart 10). Base Metals: Bullish Iron ore prices have rallied ~ 14% since the start of this year, as markets expect China to ease steel production cuts in 2022 and loosen monetary policy.  Last week, the People’s Bank of China (PBoC) cut its policy interest rate for the first time in nearly two years.  Markets expect more stimulus and policy easing in China as the central bank and government attempt to stimulate an economy mired by COVID-19 lockdowns, a property market slump and high energy prices.  Higher stimulus implies more commodity refining and manufacturing activity, including steel production, which will lead to higher iron ore demand. Precious Metals: Bullish In line with market expectations, the Federal Reserve signaled an initial rate hike in March, in its January Federal Open Market Committee (FOMC) meeting. While nominal interest rates will rise, the Fed will remain behind the inflation curve. The US CPI reading for December showed that inflation was 7% higher year-on-year, the highest annual increase in inflation since 1982 (Chart 11). High inflation and the Fed’s slow start to raise nominal interest rates will keep real rates, the opportunity cost of holding gold, low. Chart 10 Brent Forecast Restored To $80/bbl For 2022 Brent Forecast Restored To $80/bbl For 2022 Chart 11 Short Squeezes In Copper, Nickel Highlight Tight Metals Markets Short Squeezes In Copper, Nickel Highlight Tight Metals Markets     Footnotes 1     Please see 2022 Key Views: Past As Prelude For Commodities, published on December 16, 2021 for additional discussion. 2     Please see Column: Nickel gripped by ferocious squeeze as stocks disappear: Andy Home, published by reuters.com on January 20, 2022; and LME copper spreads backwardated amid stock squeeze, published by argusmedia.com on October 20, 2021. 3    This was flagged most recently in the IEA's January 2022 Oil Market Report, which noted, "While the number of Omicron cases is surging worldwide, oil demand defied expectations in 4Q21, rising by 1.1 mb/d to 99 mb/d. In 1Q22, demand is set for a seasonal decline, exacerbated by more teleworking and less air travel. We have raised our global demand estimates by 200 kb/d for 2021 and 2022 – resulting in growth of 5.5 mb/d and 3.3 mb/d, respectively – due to softer Covid restrictions."  Please see Higher Output Needed To Constrain Oil Prices for our latest oil balances and price forecasts.  We published this report last week. 4    Please see International Copper Study Group press release of January 2022. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021, for a discussion of these risks. 6    Please see Footnote 2 above.     Investment Views and Themes Recommendations Strategic Recommendations Trades Closed In 2021 Image

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? ...Could The Same Happen To US Stocks? ...Could The Same Happen To US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse CAD/SEK Could Reverse CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Our top five “black swan” risks for 2022: Social unrest in China; Russian invasion of all of Ukraine; unilateral Israeli strikes on Iran; a cyber attack that goes kinetic; and a failure of OPEC 2.0. Too early to buy the dip on Russian assets: President Biden says Putin will probably “move in” and re-invade Ukraine, Russian embassy staff have been evacuating Ukraine, the US and UK have been providing more arms to Ukraine, and the US is warning of a semiconductor embargo against Russia. Talks resume in Geneva on Friday. Tactically investors should take some risk off the table, especially if linked to Russia and Europe.  Stay short the Russian ruble and EM Europe; stay short the Chinese renminbi and Taiwanese dollar; stay long cyber security stocks; and be prepared for oil volatility. Convert tactical long equity trades to relative trades: long large caps versus small caps, long defensives versus cyclicals, and long Japanese industrials versus German industrials. Feature Chart 1Recession Probability And Yield Curve Recession Probability And Yield Curve Recession Probability And Yield Curve The 2/10-year yield curve is flattening and now stands at 79 bps, while the implied probability of a recession over the next 12 months troughed at 5.9% in April 2021, and as of December 2021 stood at 7.7% (Chart 1). Apparently stagflation and recession are too high of a probability to constitute a “black swan” risk for this year. Black swans are not only high impact but also low probability. In this year’s annual “Five Black Swan” report, the last of our 2022 outlook series, we concentrate on impactful but unlikely events. These black swans emerge directly from the existing themes and trends in our research – they are not plucked at random. The key regions are highlighted in Map 1. Chart Black Swan #1: Major Social Unrest Erupts In China China’s financial problems are front and center risks for investors this year. They qualify as a “Gray Rhino” rather than “Black Swan” risk.1 It is entirely probable that China’s financial and property sector distress will negatively impact Chinese and global financial markets in 2022. What investors are not expecting is an eruption of social unrest in China that fouls up the twentieth national party congress this fall and calls into question the Communist Party’s official narrative that it is handling the pandemic and the underlying economic transition smoothly. Social unrest is a major risk around the world in the face of the new bout of inflation. Most of the democracies have already changed governments since the pandemic began, recapitalizing their political systems, but major emerging markets – Russia, India, Turkey, Brazil – have not done so. They have seen steep losses of popular support for both political leaders and ruling parties. There is little opinion polling from China and people who are surveyed cannot speak openly. It is possible that the government’s support has risen given its minimization of deaths from the pandemic. But it is also possible that it has not. Beijing’s policies over the past few years have had a negative impact on the country’s business elite and foreign relations. There are disgruntled factions within China, though the current administration has a tight grip over the main organs of power. Since President Xi is trying to clinch his personal rule this fall, sending China down a path of autocracy that proved disastrous under Chairman Mao Zedong, it is possible he will face surprise resistance. China’s economic growth is decelerating, clocking in at a 4.0% quarter-on-quarter growth rate at the end of last year. While authorities are easing policy to secure the recovery, there is a danger of insufficient support. Private sentiment will remain gloomy, as reflected by weak money velocity and a low propensity to spend among both businesses and households (Chart 2). The government will continue to be repressive in the lead up to the political reshuffle. At least for the first half of the year the economy will remain troubled. Structurally China is ripe for social unrest. It suffers from high income inequality and low social mobility, comparable to the US and Brazil, which are both struggling with political upheaval (Chart 3). Chart 2China's Private Sector Still Depressed China's Private Sector Still Depressed China's Private Sector Still Depressed ​​​​​ Chart 3 ​​​​​​ In addition China is keeping a stranglehold over Covid-19. This “Zero Covid” policy minimizes deaths but suppresses economic activity. Strict policy has also left the population with a very low level of natural immunity and the new Omicron variant is even more contagious than other variants. Hence the regime is highly likely to double down to prevent an explosive outbreak. The service side of the economy will continue to suffer if strict lockdowns are maintained, exacerbating household and business financial difficulties (Chart 4). Yet in other countries around the world, government decisions to return to lockdowns have sparked unrest. Chart 4Zero Covid Policy: Not Sustainable Beyond 2022 Zero Covid Policy: Not Sustainable Beyond 2022 Zero Covid Policy: Not Sustainable Beyond 2022 China’s “Misery Index” (unemployment plus inflation) is rising sharply. While misery is ostensibly lower than that of other emerging markets, China’s unemployment data is widely known to be unreliable. If we take a worst-case scenario, looking at youth unemployment and fuel prices, misery is a lot higher (Chart 5). The youth, who are having the hardest time finding jobs, are also the most likely to protest if conditions become intolerable (Chart 6). Of course, if social unrest is limited to students, it will lack support among the wider populace. But it is inflation, not youth activism, that is the reason for China’s authorities to be concerned, as inflation is a generalized problem that affects workers as well as students. Chart 5China's Misery Index Is Higher Than It Looks China's Misery Index Is Higher Than It Looks China's Misery Index Is Higher Than It Looks ​​​​​ Chart 6China's Troubled Youth China's Troubled Youth China's Troubled Youth Why would protesters stick their necks out knowing that the Communist Party will react ferociously to any sign of instability during President Xi Jinping’s political reshuffle? True, mainland Chinese do not have the propensity to political activism that flared up in protests in Hong Kong in recent years. Also the police state will move rapidly to repress any unrest. Yet the entire focus of Xi Jinping’s administration, since 2012, has been the restoration of political legitimacy and prevention of popular discontent. Xi has cracked down on corruption, pollution, housing prices, education prices, and has announced his “Common Prosperity” agenda to placate the low and middle classes.2 The regime has also cracked down on the media, social media, civil society, and ideological dissent to prevent political opposition from taking root. If the government were not concerned about social instability, it would not have been adopting these policies. Disease, often accompanied by famines or riots, has played a role in the downfall of six out of ten dynasties, so Beijing will not be taking risks for granted (Table 1). Table 1Disease And Downfall Of Chinese Dynasties Five Black Swans For 2022 Five Black Swans For 2022 Social instability would have a major impact as it would affect China’s stability and global investor sentiment toward China. Western democracies would penalize China for violations of human rights, leaving China even more isolated. Bottom Line: Investors should stay short the renminbi and neutral Chinese equities. Foreign investors should steer clear of Chinese bonds in the event of US sanctions. After the party congress this fall there will be an opportunity to reassess whether Xi Jinping will “let a hundred flowers bloom,” thus improving the internal and external political and investment environment, but this is not at all clear today. Black Swan #2: Russia Invades All (Not Just Part) Of Ukraine US-Russia relations are on the verge of total collapse and Russian equities have sold off, in line with our bearish recommendations in reports over the past two years. Russia’s threat of re-invading Ukraine is credible. Western nations are still wishy-washy about the counter-threat of economic sanctions, judging by German Chancellor Olaf Scholz’s latest comments, and none are claiming they will go to war to defend Ukraine.3 Russia is looking to remove the threat of Ukraine integrating militarily and economically with the West. The US and UK are providing Ukraine with defense weaponry even as Russia specifically demands that they cease to do so. President Putin may choose short-term economic pain for long-term security gain. The consensus view is that if Russia does invade, it will undertake a limited invasion. But what if Russia invades all of Ukraine? To be clear, a full invasion is unlikely because it would be far more difficult and costly for Russia. It would go against Putin’s strategy of calculated risk and limited conflict. Table 2 compares Russia and Ukraine in size and strength, alongside a comparison of the US and Iraq in 2002. This is not a bad comparison given that Ukraine’s and Iraq’s land area and active military personnel are comparable. Table 2Russia-Ukraine Balance Of Power 2022 Compared To US-Iraq 2002 Five Black Swans For 2022 Five Black Swans For 2022 Russia would be biting off a much bigger challenge than the US did. Ukraine’s prime age population is 2.5 times larger than Iraq’s in 2002, and its military expenditure is three times bigger. The US GDP and military spending were 150 and 250 times bigger than Iraq’s, while Russia’s GDP and military spending are about ten times bigger than Ukraine’s today. Iraq was not vital to American national security, whereas Ukraine is vital to Russia; Russia has more at stake and is willing to take greater risks. But Ukraine is in better shape to resist Russian occupation than Iraq was to resist American. The point is that the US invasion went smoothly at first, then got bogged down in insurgency, and ultimately backfired both in political and geopolitical terms. Russia would be undertaking a massive expense of blood and treasure that seems out of proportion with its goal, which is to neutralize Ukraine’s potential to become a western defense ally and host of “military infrastructure.” However, there are drawbacks to partial invasion. The remainder of the Ukrainian state would be unified and mobilized, capable of integrating with the western world, and willing to support a permanent insurgency against Russian troops in eastern Ukraine. Russia has forces in Belarus, Crimea, and the Black Sea, as well as on Ukraine’s eastern border, giving rise to fears that Russia could attempt a three-pronged invasion of the whole country. In short, it is conceivable that Russian leaders could make the Soviet mistake of overreaching in the military aims, or that a war in eastern Ukraine could inadvertently expand into the west. If Russia tries to conquer all of Ukraine, the global impact will be massive. A war of this size on the European continent for the first time since World War II would shake governments and populations to their bones. The borders with Poland, Romania, the Baltic states, Slovakia, Hungary, Finland and the Black Sea area would become militarized (Map 2). Chart NATO actions to secure its members and fortify their borders would exacerbate tensions with Russia and fan fears of a wider war. Trade flows would become subject to commerce destruction, affecting even neutral nations, including in the Black Sea. Energy supplies would tighten further, sending Russia and probably Europe into recession. The disruption to business and travel across eastern Europe would be deep and lasting, not only due to sanctions but also due to a deep risk-aversion that would affect foreign investors in the former Soviet Union and former Warsaw Pact. Germany would be forced to quit sitting on the fence, as it would be pressured by the US and the rest of Europe to stand shoulder to shoulder in the face of such aggression. Finland and Sweden would be much more likely to join NATO, exacerbating Russia’s security fears. Russia would suffer a drastic loss of trade, resulting in recession, and its currency collapse would feed inflation (Chart 7). Chart 7Inflation Poses Long-Term Threat To Putin Regime Inflation Poses Long-Term Threat To Putin Regime Inflation Poses Long-Term Threat To Putin Regime Ultimately the consequences would be negative for the Putin regime and Russia as a result of recession and international isolation. But in the short run the Russian people would rally around the flag and support a war designed to prevent NATO from stationing missiles on their doorstep. And their isolation would not be total, as they would strengthen ties with China and conduct trade via proxy states in the former Soviet Union. Bottom Line: A full-scale invasion of all of Ukraine is highly unlikely because it would be so costly for Russia in military, economic, and political terms. But the probability is not zero, especially because a partial re-invasion could lead to a larger war. While global investors would react in a moderate risk-off matter to a limited war in eastern Ukraine, a full-scale war would trigger a massive global flight to safety as it would call into question the entire post-WWII peace regime in Europe. Black Swan #3: Israel Attacks Iran The “bull market in Iran tensions” continues as there is not yet a replacement for the 2015 nuclear deal that the US abrogated. Our 2022 forecast that the UAE would get caught in the crossfire was confirmed on January 17 when Iran-backed Houthi rebels expanded their range of operations and struck Abu Dhabi (Map 3). The secret war is escalating and US-led diplomacy is faltering. Chart Iran is not going to give up its nuclear program. North Korea achieved nuclear arms and greater military security and is now developing first and second strike capabilities. Meanwhile Ukraine, which faces another Russian invasion, exemplifies what happens to regimes that give up nuclear arms (as do Libya and Iraq). Iran appears to be choosing the North Korean route. While we cannot rule out a minor agreement between President Biden and Iranian President Ebrahim Raisi, we can rule out a substantial deal that halts Iran’s nuclear and missile progress. Here’s why: Any day now Iran could reach nuclear “breakout capacity,” with enough highly enriched uranium to construct a nuclear device (Table 3).4 Table 3Iran’s Violations Of 2015 Nuclear Deal Since US Exit Five Black Swans For 2022 Five Black Swans For 2022 Within Iran’s government, the foreign policy doves have been humiliated and kicked out of office while the hawks are fully in control. No meaningful agreement can be reached before 2024 because of the risk that the US will change ruling parties again and renege on any promises. Iran is highly incentivized to make rapid progress on its nuclear program now. The US will not be able to lead the P5+1 coalition to force Iran to halt its program because of its ongoing struggles with Russia and China. China is striking long-term cooperation deals with Iran. Israel has a well-established record of taking unilateral action, specifically against regional nuclear programs, known as the “Begin Doctrine.”5 Israel’s threats are credible on this front, although Iran is a much greater operational challenge than Iraq or Syria. Iran’s timeline from nuclear breakout to deliverable nuclear weapon is 12-24 months.6 Iran’s missile program is advanced. Missile programs cannot be monitored as easily as nuclear activity, so foreign powers base the threshold on nuclear capability rather than missile capability. Iran had a strong incentive to move slowly on its nuclear and missile programs in earlier years, to prevent US and Israeli military interference. But as it approaches breakout capacity it has an incentive to accelerate its tempo to a mad dash to achieve nuclear weaponization before the US or Israel can stop it. Now that time may have come. The Biden administration is afraid of higher oil prices and Israeli domestic politics are more divided and risk-averse than before. And yet Iran’s window might close in 2025, as the US could turn aggressive again depending on the outcome of the 2024 election. Hence Iran has an incentive to make its dash now. The US and Israel will restate their red lines against Iranian nuclear weaponization and brandish their military options this year. But the Biden administration will be risk-averse since it does not want to instigate an oil shock in an election year. Israel is more likely than the US to react quickly and forcefully since it is in greatest danger if Iran surprises the world with rapid weaponization. Here are the known constraints on unilateral Israeli military action: Limited Israeli military capability: Israel would have to commit a large number of aircraft, leaving its home front exposed, and even with US “bunker buster” bombs it may not penetrate the underground Fordow nuclear facility.7 Limited Israeli domestic support: The Israeli public is divided on whether to attack Iran. The post-Netanyahu government recently came around to endorsing the US’s attempt to renegotiate the nuclear deal. Limited US support: Washington opposes Israeli unilateralism that could entangle the US into a war. Israel cannot afford to alienate the US, which is its primary security guarantor. Iranian instability: The Iranian regime is under economic distress due to “maximum pressure” sanctions. It is vulnerable to social unrest, not least because of its large youth population. These constraints have been vitiated in various ways, which is why we raise this Israeli unilateralism as a black swan risk: Where there’s a will, there’s a way: If Israel believes its existence will be threatened, it will be willing to take much greater operational risks. It has already shown some ability to set back Iran's centrifuge program beyond the expected.8 Israeli opinion will harden if Iran breaks out: If Iran reaches nuclear breakout or tests a nuclear device, Israeli opinion will harden in favor of military strikes. Prime Minister Naftali Bennett has an incentive to take hawkish actions before he hands the reins of government over to a partner in his ruling coalition as part of a power-sharing agreement. The ruling coalition is so weak that a collapse cannot be ruled out. US opposition could weaken: Biden will have to explore military options if talks fail and Iran reaches nuclear breakout capacity. Once the midterms are over, Israel may have even more freedom to act, while a gridlocked Biden may be looking to shift his focus to foreign policy. Iranian stability: Iran’s social instability has not resulted in massive unrest or regime fracture despite years of western sanctions and a global recession/pandemic. Yet now energy prices are rising and Iran has less reason to believe sanction regimes will be watertight. From Israeli’s point of view, even regime change in Iran would not remove the nuclear threat once nuclear weapons are obtained. Finally, while Israel cannot guarantee that military strikes would successfully cripple Iran’s nuclear program and prevent weaponization, Israel cannot afford not to try. It would be a worse outcome to stand idly by while Iran gets a nuclear weapon than to attack and fail to set that program back. Hence the likeliest outcome over the long run is that Iran pursues a nuclear weapon and Israel attacks to try to stop it, even if that attack is likely to fail (Diagram 1). Diagram 1Game Theory: Will Israel Attack Iran? Five Black Swans For 2022 Five Black Swans For 2022 Bottom Line: A unilateral Israeli strike is unlikely but would have a massive impact, as 21% of global oil and 26% of natural gas flows through the Strait of Hormuz, and conflict could disrupt regional energy production and/or block passage through the strait itself. Black Swan #4: Cyber Attacks Spill Into Real World Investors are very aware of cyber security risks – it holds a respectable though not commanding position in the ranks of likely crisis events (Table 4). Our concern is that a cyber attack could spill over into the real world, impairing critical infrastructure, supply chains, and/or prompting military retaliation. Table 4Cyber Events Underrated In Consensus View Of Global Risks Five Black Swans For 2022 Five Black Swans For 2022 Russian attacks on US critical infrastructure by means of ransomware gangs disrupted a US fuel pipeline, meat-packing plant, and other critical infrastructure in 2021. Since then the two countries have engaged in negotiations over cyber security. The Russian Federal Security Bureau has cracked down on one of the most prominent gangs, REvil, in a sign that the US and Russia are still negotiating despite the showdown over Ukraine.9 Yet a re-invasion of Ukraine would shatter any hope of cooperation in the cyber realm or elsewhere. Russia is already using cyberattacks against Ukraine and these activities could expand to Ukraine’s partners if the military conflict expands. Should the US and EU impose sweeping sanctions that damage Russia’s economy, Russia could retaliate, not only by tightening energy supply but also by cyber attacks. Any NATO partners or allies would be vulnerable, though some states will be more reactive than others. Interference in the French election, for example, would be incendiary. The key question is: if Russia strikes NATO states with damaging cyber attacks, at what point would it trigger Article V, the mutual defense clause? There are no established codes of conduct or red lines in cyber space, so the world will have to learn each nation’s limits via confrontation and retaliation. Similar cyber risks could emerge from other conflicts. China is probably not ready to invade Taiwan but it has an interest in imposing economic costs on the island ahead of this fall’s midterm elections. Taiwan’s critical role in the semiconductor supply chain means that disruptions to production would have a global impact. Israel and the US have already used cyber capabilities to attack Iran and set back its nuclear program. These capabilities will be necessary as Iran approaches breakout capacity. Yet Iran could retaliate in a way that disrupts oil supplies. North Korea began a new cycle of provocations last September, accelerated missile tests over the past four months, and is dissatisfied with the unfinished diplomatic business of the Trump administration. In the wake of the last global crisis, 2010, it staged multiple military attacks against South Korea. South Korea may be vulnerable due to its presidential elections in May. The semiconductor or electronics supply chain could be interrupted here as well as in Taiwan. Bottom Line: There is no code of conduct in cyber space. As geopolitical tensions rise, and nations test the limits of their cyber capabilities, there is potential for critical infrastructure to be impaired. This could exacerbate supply chain kinks or provoke kinetic responses from victim nations. Black Swan #5: OPEC 2.0 Falls Apart The basis of the OPEC 2.0 cartel is Russian cooperation with Saudi Arabia to control oil supply and manage the forward price curve. Backwardation, when short-term prices are higher than long-term, is ideal for these countries since they fear that long-term prices will fall. In a world where Moscow and Riyadh both face competition from US shale producers as well as the green energy revolution, cooperation makes sense. Yet the two sides do not trust each other. Cooperation broke down both in 2014 and 2020, sending oil prices plunging. Falling global demand ignited a scramble for market share. Interestingly, Russian military invasions have signaled peak oil price in 1979, 2008, and 2014. Russia, like other petro-states, has greater room for maneuver when oil revenues are pouring in. But high prices also incentivize production, disincentivize cartel discipline, and trigger reductions in global demand (Chart 8). Chart 8Russian Invasions And Oil Price Crashes Russian Invasions And Oil Price Crashes Russian Invasions And Oil Price Crashes Broadly speaking, Saudi oil production rose modestly during times of Russian military adventures, while overall OPEC production was flat or down, and Russian/Soviet production went up (Chart 9). Chart 9Saudi And OPEC Oil Production During Russian Military Adventures Saudi And OPEC Oil Production During Russian Military Adventures Saudi And OPEC Oil Production During Russian Military Adventures Since 2020, we have held that OPEC 2.0 would continue operating but that the biggest risk would come in the form of a renewed US-Iran nuclear deal that freed up Iranian oil exports. In 2014, the Saudis increased production in the face of the US shale threat as well as the Iranian threat. This scenario is still possible in 2022 but it has become a low-probability outcome. Even aside from the Iran dynamic, there is some probability that Russo-Saudi cooperation breaks down as global growth decelerates and new oil supply comes online. Bottom Line: The world’s inflation expectations are elevated and closely linked to oil prices. Yet oil prices hinge on an uneasy political agreement between Russia and Saudi Arabia that has fallen apart twice before. If Russia invades Ukraine, or if US withdraws sanctions on Iran, for example, then Saudi Arabia could make a bid to expand its market share and trigger price declines in the process. Two Bonus Black Swans: Turkey And Venezuela Turkey lashes out: Our Turkish Political Capital Index shows deterioration for President Recep Erdogan’s political capital across a range of variables (Table 5). With geopolitical pressures increasing, and domestic politics heating up ahead of the 2023 elections, Erdogan’s behavior will become even more erratic. His foreign policy could become aggressive, keeping the lira under pressure and/or weighing on European assets. Table 5Turkey: Erdogan’s Political Capital Wearing Thin Five Black Swans For 2022 Five Black Swans For 2022 Venezuela’s Maduro falls from power: Venezuelan regime changes often follow from military coups. These coups do not only happen when oil prices collapse – sometimes the army officers wait to be sure prices have recovered. Coup-throwers want strong oil revenues to support their new rule. An unexpected change of regimes would affect the oil market due to this country’s giant reserves. Bottom Line: Turkey’s political instability could result in foreign aggression, while Venezuela’s regime could collapse despite the oil price recovery. Investment Takeaways We are booking profits on our tactical long trades on large caps and defensive sectors. We will convert these to relative trades: long large caps over small caps, and long defensives over cyclicals. We also recommend converting our tactical long Japan trade into long Japanese industrials / short German industrials equities. If US-Russia diplomacy averts a war we will reconsider.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      “Gray Rhino” is a term coined by author Michele Wucker to describe large and probable risks that people neglect or avoid. For more, see thegrayrhino.com. 2     Xi Jinping recently characterized the “common prosperity” agenda as follows: “China has made it clear that we strive for more visible and substantive progress in the well-rounded development of individuals and the common prosperity of the entire population. We are working hard on all fronts to deliver this goal. The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements. As a rising tide lifts all boats, everyone will get a fair share from development, and development gains will benefit all our people in a more substantial and equitable way.” See World Economic Forum, “President Xi Jinping’s message to The Davos Agenda in full,” January 17, 2022, weforum.org. 3     Chancellor Scholz, when asked whether Germany would avoid using the Nord Stream II pipeline if Russia re-invaded Ukraine, said, "it is clear that there will be a high cost and that all this will have to be discussed if there is a military intervention against Ukraine.” He was speaking with NATO Secretary-General Jens Stoltenberg. See Hans Von Der Burchard, “Scholz: Germany will discuss Nord Stream 2 penalties if Russia attacks Ukraine,” Politico, January 18, 2022, politico.eu. 4     For the Begin Doctrine, see Meir Y. Soloveichik, “The Miracle of Osirak,” Commentary, April 2021, commentary.org. 5     The estimate of 12-24 months to mount a nuclear warhead on a missile has been cited by various credible sources, including David Albright and Sarah Burkhard, “Highlights of Iran’s Perilous Pursuit of Nuclear Weapons,” Institute for Science and International Security, August 24, 2021, isis-online.org, and Eric Brewer and Nicholas L. Miller, “A Redline for Iran?” Foreign Affairs, December 23, 2021, foreignaffairs.com. 6     See Edieal J. Pinker, Joseph Szmerekovsky, and Vera Tilson, “Technical Note – Managing a Secret Project,” Operations Research, February 5, 2013, pubsonline.informs.org, as well as “What Can Game Theory Tell Us About Iran’s Nuclear Intentions?” Yale Insights, March 17, 2015, insights.som.yale.edu.  7     See Josef Joffe, “Increasingly Isolated, Israel Must Rely On Nuclear Deterrence,” Strategika 35 (September 2016), Hoover Institution, hoover.org. 8     The sabotage of the Iran Centrifuge Assembly Center at the Natanz nuclear facility in July 2020 “set back Iran’s centrifuge program significantly and continues to do so,” according to David Albright, Sarah Burkhard, and John Hannah, “Iran’s Natanz Tunnel Complex: Deeper, Larger Than Expected,” Institute for Science and International Security, January 13, 2022, isis-online.org. For a recent positive case regarding Israel’s capabilities, see Mitchell Bard, “Military Options Against Iran,” Jewish Virtual Library, American-Israeli Cooperative Enterprise, January 2022, jewishvirtuallibrary.org.  9     For the FSB and REvil, see Chris Galford, “Russian FSB arrests members of REvil ransomware gang following attacks on U.S. infrastructure,” Homeland Preparedness News, January 18, 2022, homelandprepnews.com. For the Colonial Pipeline and JBS attacks, and other ransomware attacks, see Jonathan W. Welburn and Quentin E. Hodgson, “How the United States Can Deter Ransomware Attacks,” RAND Blog, August 9, 2021, rand.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights The Kingdom of Saudi Arabia (KSA), Iraq, the UAE and Kuwait – the OPEC 2.0 states capable of increasing production this year – will have to step up for coalition members unable to lift output, including Russia. US shale-oil output also will have to increase to cover demand. The COVID-19 omicron variant has proven to be less severe than anticipated, which likely will translate into a faster recovery in oil demand than was expected in December. One risk looms large: China's zero-COVID policy greatly reduced virus transmission in the country; however, this also reduced natural antibody protection in its population. This is exacerbated by a lack of mRNA vaccine availability. Faltering supply and strong demand will keep inventories tight, reducing buffers to supply shocks – e.g., the Kirkuk–Ceyhan Oil Pipeline explosion this week. We are returning our Brent forecast for 2022 to $80/bbl; for 2023, we continue to expect $81/bbl (Chart of the week). Our forecast assumes OPEC 2.0 will increase supply so as to keep Brent prices below $90/bbl. US shale-oil output also is expected to rise. We continue to see oil-price risk skewed to the upside. Still, demand-destruction from high prices or widespread omicron-induced lockdowns remain clear risks to our outlook. Feature Given the relatively mild symptoms associated with the COVID-19 omicron variant, global oil demand likely will continue to recover lost ground and return to trend sooner than expected. Faltering supply from OPEC 2.0 member states means prices will remain elevated, and perhaps push higher. On the back of these fundamentals, we are restoring our Brent price forecast to $80/bbl for this year, and $81/bbl for 2023. This is the consensus view, and we find ourselves in the uncomfortable position of sharing it. Chart 1 Presently, the oil market is bulled up, expecting high prices this year and next, with Brent forecasts clustering in the $80-$85/bbl range out to 2025.1 Some headline-grabbing forecasts call for $100-plus prices, as top OPEC 2.0 producers – e.g. Russia, Angola and Nigeria– continue to strain in their efforts to restore production, and demand remains buoyant (Chart 2). Chart 2 A consensus usually emerges after most market participants have adjusted their positioning to reflect a commonly held view. This usually is a temporary equilibrium. The market typically finds the highest-pain price trajectory required to shatter the consensus view – e.g., selling off because widely held demand expectations are too high or supply expectations are too low, and vice versa. Ultimately, a fundamental shock destabilizes the consensus, and prices move higher or lower to reflect the new reality. The biggest risks to our price forecast are demand destruction from high prices or widespread omicron-induced lockdowns.2 To keep prices from finding a new equilibrium above $90/bbl, a policy response from OPEC 2.0 to increase production will be required. In addition, US shale-oil output will have to increase. This is not to say we are dismissing above-consensus price realizations: Inventories will continue to draw hard as long as the level of supply remains below demand. This will leave little in the way of buffer stocks to even out price spikes, as the Ceyhan pipeline explosion demonstrated earlier this week.3 Geopolitical tensions are high in eastern Europe as Russia and the West square off, and in the Persian Gulf as Iran squares off against GCC states and the US.4 These structural and geopolitical risks leave markets exposed to volatile price spikes. OPEC 2.0 Falters Chart 3 Chart 4 Our forecast is contingent on the core OPEC 2.0 member states ex-Russia – KSA, Iraq, the UAE and Kuwait – increasing production by an average of ~ 3.34mmb/d in 2022 and 2.76 mmb/d in 2023 relative to 2021. Most of the increases comes from KSA, Iraq and UAE (Chart 3). In addition, we expect US shale-oil producers to increase their average output by 0.6mm b/d this year, and 1.07mm b/d in 2023 relative to 2021 (Chart 4). In 2022, US crude oil supply reaches 11.7mm b/d, and in 2023 it goes to 12.13mm b/d in our estimates. The slower increase in US output this year largely is a function of the delay we expect in assembling rigs and crews to significantly lift production from current levels. These production increases are needed to make up for ongoing downgrades of OPEC 2.0 member states' ability to increase output, including Russia, where we expect crude oil production to remain flat at a little over 10mm b/d this year on average (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Higher Output Needed To Constrain Oil Prices Higher Output Needed To Constrain Oil Prices Back in July 2021, the coalition agreed to restore 400k b/d of production taken off the market in the wake of COVID-19 demand destruction. Thus far, the coalition has only managed to restore ~ 1.86mm b/d of the 2mm b/d pledged for August to December 2021, according to the Oxford Institute for Energy Studies (OIES). For this year, the OIES notes OPEC 2.0 "will struggle to return more than 2 mb/d of withheld supplies in 2022, compared to the headline target of 3.76 mb/d."5 Our view rests on a policy call at the end of the day: We believe OPEC 2.0 – KSA in particular – is well aware of the demand-destruction potential high nominal prices and a strong USD pose, particularly as the US Fed is embarking on a rate-hike program to accompany the quantitative-tightening measures recently adopted. Absent a concerted effort to raise production by the core OPEC 2.0 states ex-Russia and the US shale producers, prices could move above $86/bbl as supply tightens and demand continues to rise. This can be seen in The Chart of the Week (the dashed brown curve depicting our estimate for prices without higher production). Importantly, even if such a concerted effort emerges, a failure to resolve the Iran nuclear talks with the US and its allies this year would keep more than 1mm b/d of production from returning to the market. This would push average Brent prices this year and next to or above $90/bbl. Oil Demand Recovery To Continue Provided we do not see widespread lockdowns resulting from the rapid transmission of the omicron variant, we expect global demand to grow close to 4.8mm b/d this year and 1.6mm b/d in 2023 (Chart 5). This reflects our view that – baring too-high prices or another full-scale COVID-induced lockdown in a key market like China – demand resumes its return to trend. It is important to point out that the increase in oil demand we expect is being driven by economic growth, which means consumers likely can withstand high prices, just as long as they do not become excessive – i.e., entrenched above $90/bbl in our view. Chart 5Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Chart 6OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand In our base case model, we continue to see markets remaining balanced (Chart 6) – assuming we get the policy calls right – and OECD oil inventories falling (Chart 7). Even with an uptick in inventories, which presently are 31.5mm barrels above the 2010-14 average, days-forward-cover for the OECD will remain low (Chart 8). Chart 7Crude Inventories Continue To Draw Crude Inventories Continue To Draw Crude Inventories Continue To Draw Chart 8 Investment Implications The consensus view calls for oil prices to remain at current elevated levels, and to perhaps push higher. We share that view – and have maintained it for some time – which gives us pause. A consensus not only reflects a shared view. It likely reflects broad similarities in the way market participants are positioned in their capex, investment and trading outlooks. This is inherently unstable. We expect oil prices to remain elevated, and have returned our 2022 Brent forecast to $80/bbl on average. Our 2023 forecast for Brent remains $81/bbl. We continue to recommend positions that benefit from tightening markets in which forward curves are backwardated and likely to remain so. Even if we see production increasing – from the OPEC 2.0 core producers ex-Russia and the US shales – we still expect forward Brent and WTI curves to remain backwardated (prompt-delivery prices exceed deferred-delivery prices). We remain long the S&P GSCI and the COMT ETF to express this view. If we fail to see production increase to keep prices from breaching and sustaining levels above $90/bbl, long index exposure will post higher gains. The risk to our view is two-fold: 1) High prices leading to demand-destruction, which is made more acute when the USD is strong; and 2) widespread omicron-induced lockdowns, which could once again reduce consumption and lead to global supply-chain gridlock. High prices leading to demand destruction, or another round of lockdowns would force us to reconsider our positioning.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish It's very early days, but EU experts are reviewing a draft plan leaked to the media earlier this month, which could result in gas- and nuclear-powered generation being included among sustainable energy sources, and suitable to bridge the global energy transition to renewable power. The draft of the common classification system for EU funding of sustainable economic activities, or taxonomy, apparently states gas plants can earn a “transitional” label if they meet several criteria, including an emissions limit of 270g of CO2e/kWh, or if their annual emissions average 550kg CO2e/kW or less over 20 years. This criterion would be applied to judging environmental performance of a gas plant over 20 years, but offers no guarantee that its emissions would drop over time. The chair of the expert panel said draft rules for nukes raised questions over "whether a plant can guarantee its green credentials today, if its obligation to manage nuclear waste – one of the main environmental concerns about the fuel – does not kick in until as late as 2050," according to euractiv.com, which broke the story earlier this month. Base Metals: Bullish Indonesia has become more restrictive with exports of raw commodities in order to attract more downstream investments and to play a bigger role in producing finished goods. Of these commodities, Indonesia’s supply of nickel, relative to the world is the highest, constituting ~ 38% of total global nickel supply. In 2020, the nation banned nickel ore exports, and is now considering a progressive export tax on low nickel content products such as ferronickel and nickel pig iron. This tax could reduce foreign investment in Indonesia’s nickel mines and global supply, which would, all else equal, support prices. These developments arrive on the back of low nickel inventories, which helped prices of the key battery metal reach a 10-year high last week (Chart 9).   Precious Metals: Bullish In 2021, gold ETFs were hit by outflows of ~ $9 billion, the main reason the yellow metal was unable to reach its 2020 high above the $2,000/oz mark (Chart 10). For this year, we expect a supportive gold market, as real interest rates will remain weak despite the Fed’s hawkish tilt to lift nominal interest rates higher. In line with BCA’s Foreign Exchange Strategy service, we expect the USD to fall over the 12-18 month horizon, which will also bolster gold. Chart 9 Tighter Nickel Balances Going Forward Will Push Prices Higher Tighter Nickel Balances Going Forward Will Push Prices Higher Chart 10       Footnotes 1     Please see Column: Oil prices expected to rise with big variation in projections: Kemp, published by reuters.com on January 19, 2022. 2     High nominal oil prices and a strong USD compound the former demand-destruction risk.  The latter risk of wide-spread omicron-induced lockdowns is elevated in China at present.  Its success in shutting down the transmission of earlier COVID-19 mutations has reduced the amount of antibodies to the virus in the population.  This is compounded by a lack of mRNA vaccine production and distribution, which leaves the country at risk to wide-spread omicron transmission.  In states with large shares of the population carrying COVID-19 antibodies – e.g., the UK – omicron is less of a risk and is on course to becoming endemic.  Please see 2022 Key Views: Past As Prelude For Commodities and Endemic COVID-19 Will Spur Commodities' Next Leg Higher which we published on December 16, 2021 and January 13, 2022 for discussions. 3    Oil flows are expected to return to normal in short order.  Please see Halted Iraq-Turkey flows to resume within hour: Botas, published by argusmedia.com on January 19, 2022. 4    Please see Russia/Ukraine: Implications From Kazakhstan and Geopolitical Charts For The New Year published by BCA Research's Geopolitical Strategy service on January 7 and 14, 2022, respectively, for discussions. 5    Please see Key Themes for the Global Energy Economy in 2022 published by the Oxford Institute for Energy Studies on January 18, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Highlights The bond market assumes that when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. High inflation is followed by lower than average inflation. This means that the ex-post real yield delivered by 10-year T-bonds will turn out to be much higher than the negative ex-ante real yield that 10-year Treasury Inflation Protected Securities (TIPS) are now offering. Long-term investors should overweight 10-year T-bonds versus 10-year TIPS. Underweight (or outright short) US TIPS. Underweight commodities, and especially underweight those commodities that have not yet corrected. Fractal trading watchlist: the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. Feature Chart of the WeekThe Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected Real interest rates are negative. Or are they? Given that real interest rates form the foundation of most asset prices, getting this question right is of paramount importance. Over the short term, yes, real interest rates are negative. Policy interest rates in the major developed economies are unlikely to rise quickly from their current near-zero levels. So, they will remain below the rate of inflation. But what about over the longer term, say ten years – are long-term real interest rates truly negative? The Real Bond Yield Is The Mirror Image Of Backward-Looking Inflation The negative US real 10-year bond yield of -0.7 percent comprises the nominal yield of 1.8 percent minus an expected inflation rate of 2.5 percent. This means that the negativity of the real bond yield hinges on the expectation for inflation over the next ten years. Therein lies the big problem. Many people believe that the bond market’s expected 10-year inflation rate is an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. Specifically, in the pandemic era, the bond market has derived its expected 10-year inflation rate from the historic six month (annualized) inflation rate, which it assumes will gradually converge to a long-term rate of just below 2 percent during the first four years, then stay there for the remaining six years2 (Figure I-1). We recommend that readers replicate this simple calculation for themselves to shatter any illusion that there is anything forward-looking about the bond market’s inflation expectation! (Chart I-2). Chart I- Chart I-2Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like now or in early-2008, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words, the bond market extrapolates the last six months of inflation into the next ten years. This observation leads to an immediate investment conclusion. The US six-month inflation rate has already peaked. As it cools, it will also cool the expected 10-year inflation rate, thereby putting upward pressure on the mirror image Treasury Inflation Protected Securities (TIPS) real yield. It follows that investors should underweight (or outright short) US 10-year TIPS (Chart I-3). Chart I-3As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform The Real Bond Yield Is Based On A False Expectation There is a more fundamental issue at stake. The market assumes that when recent inflation has been low, it will be lower than average for the next ten years. And when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. The price level is lower than the 2012 expectation of where it would stand in 2022! Another way of putting this is that the market assumes that any breakout of the consumer price index (CPI) will be amplified over the following ten years (Chart I-4). Yet the reality is that any breakout of the price level tends to trend-revert over the following ten years. This means that after the CPI’s decline in late 2008, the market massively underestimated where the price level would be ten years later. But earlier in 2008, when the CPI had surged, the market massively overestimated where the price level would be ten years later. Chart I-4The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future Today in 2022, the price level seems to be uncomfortably high. But the remarkable thing is that it is still lower than the 2012 expectation of where it would stand in 2022! (Chart I-5). Chart I-5The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The crucial point is that after surges in the price level, realised 10-year inflation turns out to be at least 1 percent lower than the bond market’s expectation (Chart I-6). This means that the ex-post real yield delivered by 10-year T-bonds turns out to be at least 1 percent higher than the ex-ante real yield that 10-year TIPS offered at the start of the ten year period (Chart of the Week). Chart I-6Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected It follows that after the current surge in the price level, the (actual) real yield that will be delivered by 10-year T-bonds over the next ten years will not be the -0.7 percent indicated by the TIPS 10-year real yield. Instead, if history is any guide, it will be at least +0.3 percent. Therefore, in answer to our original question, the real long-term interest rate is almost certainly not negative. Of course, the obvious comeback is that ‘this time is different’. But we really wouldn’t bet the farm on it. Many people thought this time is different during the price level surge in early 2008 as well as the lows in late 2008 and early 2020. But those times were not different. And our bet is that this time isn’t any different either. This means that the real yield on T-bonds will turn out to be much higher than that on TIPS. Long-term investors should overweight T-bonds versus TIPS. Commodities Are Vulnerable A final important observation relates to commodities. Commodity prices have been tightly tracking the 6-month inflation rate, but which way does the causality run in this tight relationship? At first glance, it might seem that the causality runs from commodity prices to the inflation rate. Yet on further consideration, this cannot be right. It is not the commodity price level that drives the overall inflation rate, it is the commodity inflation rate that drives the overall inflation rate. And in the past year, overall inflation has decoupled (upwards) from commodity inflation (Chart I-7 and Chart I-8). Chart I-7Inflation Is Tracking ##br##Commodity Prices... Inflation Is Tracking Commodity Prices... Inflation Is Tracking Commodity Prices... Chart I-8...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation Therefore, the causality in the tight relationship between the 6-month inflation rate and commodity prices must run from backward-looking inflation to commodity prices. And the likely explanation is that investors are bidding up commodity prices as a hedge against the backward-looking inflation which they are incorrectly extrapolating into the future. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. It follows that as 6-month inflation cools, so will commodity prices. The investment conclusion is to underweight commodities, and especially to underweight those commodities that have not yet corrected. Fractal Trading Watchlist This week’s observations relate to the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. The US dollar reached a point of fragility in early December, from which it experienced a classic short-term countertrend sell-off. As such, the countertrend sell-off is mostly done. Alternative energy versus old energy is approaching a major buying point. Biotech versus the market is very close to a major buying point. Nickel versus silver is very close to a major selling point. Semiconductors versus technology was on our sell watchlist last week, and has now hit its point of maximum fragility (Chart I-9). Therefore, the recommended trade is to short semiconductors versus broad technology, setting a profit target and symmetrical stop-loss at 6 percent. Chart 9Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Inflation is based on the PCE deflator. Fractal Trading System Fractal Trades Image 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The neutral rate of interest in the US is 3%-to-4% in nominal terms or 1%-to-2% in real terms, which is substantially higher than the Fed believes and the market is discounting. The end of the household deleveraging cycle, rising wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand. In addition, deglobalization and population aging are depleting global savings, raising the neutral rate in the process. A higher neutral rate implies that monetary policy is currently more stimulative than widely perceived. This is good news for stocks, as it reduces the near-term odds of a recession. The longer-term risk is that monetary policy will stay too loose for too long, causing the US economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Investors should overweight stocks in 2022 but look to turn more defensive in late 2023. We are taking partial profits on our long December-2022 Brent futures trade, which is up 17.3% since inception. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it.  The Neutral Rate Matters At first glance, the neutral rate of interest – the interest rate consistent with full employment and stable inflation – seems like a concept only an egghead economist would care about. After all, unlike actual interest rates, the neutral rate cannot be observed in real time. The best one can do is deduce it after the fact, something that does not seem very relevant for investment decisions. While this perspective is understandable, it is misguided. The yield on a long-term bond is largely a function of what investors expect short-term rates to be over the life of the bond. Today, investors expect the Fed to raise rates to only 1.75% during this tightening cycle, a far cry from previous peaks in interest rates (Chart 1). Chart 2Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Chart 1Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates     Far from worrying that the Fed will keep rates too low for too long in the face of high inflation, investors are worried that the Fed will tighten too much. This is the main reason why the yield curve has flattened over the past three months and the 20-year/30-year portion of the yield curve has inverted (Chart 2). Secular Stagnation Remains The Consensus View Why are so many investors convinced that the Fed will be unable to raise rates all that much over the next few years? The answer is that most investors have bought into the secular stagnation thesis, which posits that the neutral rate of interest has fallen dramatically over time. The secular stagnation thesis comes in two versions: The first or “strong form” describes an economy that needs a deeply negative – and hence unattainable – nominal interest rate to reach full employment. Japan comes to mind as an example. The country has had near-zero interest rates since the mid-1990s; and yet it continues to suffer from deflation. The second or "weak form" describes the case where a country needs a low, but still positive, interest rate to reach full employment. Such an interest rate is attainable by the central bank, and hence creates a goldilocks outlook for investors where profits return to normal, but asset prices continue to get propped up by an ultra-low discount rate. The “weak form” version of the secular stagnation thesis arguably describes the United States. Post-GFC Deleveraging Pushed Down The Neutral Rate Chart 3 One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If something causes the aggregate demand curve to shift inwards, a lower real interest rate would be required to bring demand back up (Chart 3). Like many other countries, the US experienced a prolonged deleveraging cycle following the Global Financial Crisis. The ratio of household debt-to-GDP has declined by 23 percentage points since 2008. The need for households to repair their balance sheets weighed on spending, thus necessitating a lower interest rate. Admittedly, corporate debt has risen over the past decade, with the result that overall private debt has remained broadly stable as a share of GDP (Chart 4). However, the drag on aggregate demand from declining household debt was not offset by the boost to demand from rising corporate debt. Whereas falling household debt curbed consumer spending, rising corporate debt did little to boost investment spending. This is because most of the additional corporate debt went into financial engineering – including share buybacks and M&A activity – rather than capex. In fact, the average age of the private-sector capital stock has increased from 21 years in 2010 to 23.4 years at present (Chart 5). Chart 4Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Chart 5The Average Age Of Capital Stock Has Been Increasing The Average Age Of Capital Stock Has Been Increasing The Average Age Of Capital Stock Has Been Increasing Buoyant Consumer And Business Spending Will Prop Up The Neutral Rate Today, the US economy finds itself in a far different spot than 12 years ago. Households are borrowing again. Consumer credit rose by $40 billion in November, the largest monthly increase on record, and double the consensus estimate (Chart 6). Banks are easing lending standards across all consumer loan categories (Chart 7). Chart 6Big Jump In Consumer Credit Big Jump In Consumer Credit Big Jump In Consumer Credit Chart 7Banks Are Easing Lending Standards For All Consumer Loans Banks Are Easing Lending Standards For All Consumer Loans Banks Are Easing Lending Standards For All Consumer Loans Chart 8Net Worth Has Soared Over The Past Two Years Net Worth Has Soared Over The Past Two Years Net Worth Has Soared Over The Past Two Years Meanwhile, years of easy money have pushed up asset prices, a dynamic that was only supercharged by the pandemic. We estimate that household wealth rose by 145% of GDP between the end of 2019 and the end of 2021 – the largest two-year increase on record (Chart 8). A back-of-the-envelope calculation suggests that this increase in wealth could boost aggregate demand by 5%.1 Reacting to the prospect of stronger final demand, businesses are ramping up capex (Chart 9). After moving sideways for two decades, capital goods orders have soared. Surveys of capex intentions remain at elevated levels. Against the backdrop of empty shelves and warehouses, inventory investment should also remain robust. Residential investment will increase (Chart 10). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 10-month high in December. Building permits are 11% above pre-pandemic levels. Amazingly, homebuilders are trading at only 7-times forward earnings. We recommend owning the sector. Chart 9Investment Spending Will Stay Strong Investment Spending Will Stay Strong Investment Spending Will Stay Strong Chart 10US Housing Will Remain Well Supported US Housing Will Remain Well Supported US Housing Will Remain Well Supported Fiscal Policy: Tighter But Not Tight Chart 11Chinese Credit Impulse Seems To Be Bottoming Chinese Credit Impulse Seems To Be Bottoming Chinese Credit Impulse Seems To Be Bottoming As in most other countries, the US budget deficit will decline over the next few years, as pandemic-related measures roll off and tax receipts increase on the back of a strengthening economy. Nevertheless, we expect the structural budget deficit to remain 1%-to-2% of GDP larger in the post-pandemic period, following the passage of the infrastructure bill last November and what is likely to be a slimmed down social spending package focusing on green energy, universal pre-kindergarten, and health insurance subsidies. The shift towards structurally more accommodative fiscal policies will play out in most other major economies. In the euro area, spending under the Next Generation EU recovery fund will accelerate later this year, with southern Europe being the primary beneficiary. In Japan, the government has approved a US$315 billion supplementary budget. Matt Gertken, BCA’s Chief Geopolitical Strategist, expects Prime Minister Kishida to pursue a quasi-populist agenda ahead of the upper house election on July 25th.  China is also set to loosen policy. The Ministry of Finance has indicated that it intends to “proactively” support growth in 2022. For its part, the PBoC cut the reserve requirement ratio by 50 basis points on December 6th. The 6-month credit impulse has already turned up (Chart 11). More Than The Sum Of Their Parts Chart 12The Labor Share Typically Rises When Unemployment Falls The Labor Share Typically Rises When Unemployment Falls The Labor Share Typically Rises When Unemployment Falls As discussed above, the end of the deleveraging cycle, rising household wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand in the US. While each of these factors have independently raised the neutral rate of interest, taken together, the impact has been even greater. For example, stronger consumption has undoubtedly incentivized greater investment by firms eager to expand capacity. Strong GDP growth, in turn, has pushed up asset prices, leading to even more spending. Furthermore, a tighter labor market has propped up wage growth, especially among low-wage workers. Historically, labor’s share of overall national income has increased when unemployment has fallen (Chart 12). To the extent that workers spend more of their income than capital owners, a higher labor share raises aggregate demand, thus putting upward pressure on the neutral rate. The Retreat From Globalization Will Push Up The Neutral Rate… Chart 13The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade Globalization lowered the neutral rate of interest both because it shifted the balance of power from workers to businesses; and also because it allowed countries such as the US, which run chronic current account deficits, to import foreign capital rather than relying exclusively on domestic savings.  The era of hyperglobalization has ended, however. The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 13). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. … As Will Population Aging Chart 14Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Aging populations can affect the neutral rate either by dragging down investment demand or by reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 14 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades. In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 15). As baby boomers transition from net savers to net dissavers, national savings will fall, leading to a higher neutral rate. The pandemic has accelerated this trend insomuch as it has caused about 1.2 million workers to retire earlier than they would have otherwise (Chart 16). Chart 15 Chart 16Number Of Retired People Jumped During The Pandemic Number Of Retired People Jumped During The Pandemic Number Of Retired People Jumped During The Pandemic To What Extent Are Higher Rates Self-Limiting? Some commentators contend that any effort by central banks to bring policy rates towards neutral would reduce aggregate demand by so much that it would undermine the rationale for why the neutral rate had increased in the first place. In particular, they argue that higher rates would drag down asset prices, thus curbing the magnitude of the wealth effect. While there is some truth to this argument, its proponents overstate their case. History suggests that stocks tend to brush off rising bond yields, provided that yields do not rise to prohibitively high levels (Table 1). Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The New Neutral The New Neutral Chart 17The Equity Risk Premium Remains High The Equity Risk Premium Remains High The Equity Risk Premium Remains High The last five weeks are a case in point. Both 10-year and 30-year Treasury yields have risen nearly 40 bps since December 3rd. Yet, the S&P 500 has gained 2.7% since then. Keep in mind that the forward earnings yield for US stocks still exceeds the real bond yield by 552 bps, which is quite high by historic standards. The gap between earnings yields and real bond yields is even greater abroad (Chart 17). Thus, stocks have scope to absorb an increase in bond yields without a significant PE multiple contraction. Investment Implications Our analysis suggests that the neutral rate of interest in the US is substantially higher than widely believed. How much higher is difficult to gauge, but our guess is that in real terms, it is between 1% and 2%. This is substantially higher than survey measures of the neutral rate, which peg it at close to 0% in real terms (Chart 18). It is also significantly higher than 10-year and 30-year TIPS yields, which stand at -0.73% and -0.17%, respectively (Chart 19). The neutral rate has also increased in other economies, although not as much as in the US. Chart 18Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Chart 19Long-Term Real Rates Remain Depressed Long-Term Real Rates Remain Depressed Long-Term Real Rates Remain Depressed If the neutral rate turns out to be higher than the consensus view, then monetary policy is currently more stimulative than widely perceived. That is good news for stocks, as it would reduce the near-term odds of a recession. Hence, we remain positive on stocks over a 12-month horizon, with a preference for non-US equities. In terms of sector preferences, we maintain our bias for banks over tech. The longer-term risk is that monetary policy will stay too easy, causing the economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Such a day of reckoning could be reached by late 2023. Two Trade Updates We are taking partial profits on our long December-2022 Brent futures trade by cutting our position by 50%. The trade is up 17.3% since inception. Bob Ryan, BCA’s Chief Commodity Strategist, still sees upside for oil prices, so we are keeping the other half of our position for the time being. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it. While the outlook for both companies remains challenging, there is an outside chance that they will find a way to leverage their meme status to create profitable businesses. This makes us inclined to move to the sidelines.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 In line with published estimates, we assume that households spend 5 cents of every one dollar increase in housing wealth, 2 cents of every dollar increase in equity wealth, 10 cents out of bank deposits, and 2 cents out of other assets. Of the 145% of GDP in increased household net worth between the end of 2019 and the end of 2021, 19% stemmed from higher housing wealth, 52% from higher equity wealth, 12% from higher bank deposits, and 17% from other categories.    View Matrix Image Special Trade Recommendations Current MacroQuant Model Scores Image

Highlights Data from the UK revealed it is tantalizingly close to declaring COVID-19 an endemic virus, indicating Britain likely will exit the pandemic ahead of other states soon. The UK is a bellwether market regarding its public-health response to the coronavirus. Some 95% of its population is estimated to carry COVID-19 antibodies (Chart of the Week). Other states – e.g., the US, the EU – have followed the UK with a lag, which we expect will continue. While the Fed's reassurance it will be able to hike rates without disrupting labor markets no doubt encourages markets – and boosted commodity prices – we believe the return to economic normalcy that would be ushed in by endemicity will release pent-up consumer demand for goods and services. This will spur commodity demand. If COVID-19 becomes endemic in enough economies globally, it also would fuel inflation, and inflation expectations.1 Given the tight supplies of industrial commodities – chiefly oil, natural gas and base metals – our assessment of upside price risk is higher now than it was at year-end 2021. We remain long broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Feature Fed Chair Powell's confidence that the US central bank will raise rates and keep inflation under control without destabilizing labor markets stole the show earlier this week. The media credited Powell's remarks for the burst of enthusiasm that lifted commodities as an asset class higher. While none would gainsay the Fed's importance to commodity markets, we would point out the approaching endemicity of COVID-19 in the UK – and the likely follow-on from the US and other large commodity-consuming states – is of equal, if not greater, moment. The UK has been out in front on its public-health response to the COVID-19 pandemic and has become a bellwether in the northern hemisphere; the US will follow. Chart 1 This week, the UK's Office for National Statistics (ONS) reported ~ 95% of England's population tested positive for antibodies to COVID-19 via infection or vaccination in the week beginning 29 November 2021. Similar results were reported for Scotland, Wales and Northern Ireland. This is generally observed in all age cohorts tracked by ONS.2 According to David Heymann of the London School of Hygiene and Tropical Medicine, "population immunity seems to be keeping the virus and its variants at bay, not causing serious illness or death in countries where population immunity is high."3 In a briefing hosted by Chatham House this week, Heymann observed, “And probably, in the UK, it’s the closest to any country of being out of the pandemic if it isn’t already out of the pandemic and having the disease as endemic as the other four coronaviruses” currently in circulation, which are responsible for roughly a quarter of common colds.4 Based on UK government data, the ratios of hospitalizations and deaths to COVID-19 cases has been falling precipitously (Chart 2). This is encouraging, given the sharp increase in cases driven by the rapid spread of the omicron mutant, which appears to be rolling over. Medical experts in the UK suggest the data also point to a possible peaking in the omicron surge. This would lighten the load on hospitals, as well as reduce death rates attributed to the coronavirus (Chart 3).5 Chart 2 Chart 3 Return To Normal? Nothing will return commodity markets to economic normalcy faster than endemicity. If this stays on track over the next month or so, it will spur commodity demand sooner rather than later, as pent-up consumer demand for goods and services is discounted by trading markets. If, as the data appear to indicate, the UK's transition from pandemic to endemic COVID-19 is followed by other states like the US and EU a few months later, we would expect a renewed leg up in the post-pandemic commodities rally. This would be apparent in futures contracts, which already are pricing commodity deliveries a month or more hence. Such a turn of events would force us to accelerate our time table for oil-demand recovery, which we expect will come in 2H22. This could restore our $80/bbl forecast for 2022, and lift our 2023 expectation. We also would have to revisit our copper and base metals view, and bring forward the timing of the copper-price rally we expect will lift COMEX refined copper to $4.80/lb and $6.00/bbl in 2022 and 2023, respectively, on average.6 These industrial commodities would see demand increase amid extremely tight supply conditions. Oil markets are tightening on the back of OPEC 2.0's production discipline, and the inability of many member states to fully restore the 400k b/d every month it signed on for beginning in August of last year, owning to production shortfalls outside the core producers of the coalition (Chart 4). Copper, the base-metals bellwether, remains very tight, as seen in balances (Chart 5) and inventories (Chart 6). Chart 4OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works OPEC 2.0s Strategy Works Chart 5Coppers Physical Deficits Will Persist... Coppers Physical Deficits Will Persist... Coppers Physical Deficits Will Persist... Chart 6Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten China's zero-COVID-19 policy, which has resulted in numerous lock-downs at the local level, has yet to dent oil demand, which, for the time being, is hovering ~ 16mm b/d. We will be updating our oil balances and price forecasts next week, and will have a more extensive analysis of supply-demand balances then. Return Of Speculative Interest Expected With Endemicity Hedge funds have been reducing their exposure to the industrial commodities over the past year, which suggests they either have better alternatives for investing, or did not believe the rallies in commodities over the past year were durable, given the repeated demand shocks visited upon these markets by COVID-19 (Chart 7). We expect that once the pandemic becomes endemic, hedge funds will return to these markets. All the same, given the higher likelihood of price rallies in these markets, we would expect hedge funds to be cited as a cause of higher prices, as typically happens when markets take a sharp leg higher. Regular readers of our research are aware that this generally is not the case – hedge funds follow the news; they don't lead it. This past week we revisited earlier research to see if hedge-fund involvement in commodity markets causes the prices to go up or down to any meaningful degree. And, again, we found no relationship between hedge-fund positioning and the level of commodity prices.7 Chart 7 The presumed influence of hedge funds has been a persistent feature of futures markets in the post-GFC world, following the collapse of commodity prices along with financial markets in 2008. An entire literature has sprung up to explore the influence of these funds on commodity price formation. Below we highlight a few representative articles consistent with our results. Büyüksahin and Harris (2011) show hedge funds and other speculators follow prices – they do not lead them – based on the Granger-causality testing they performed on oil prices and speculative positioning.8 Brunetti et al (2016) argue hedge funds' trading stabilizes markets – i.e., they provide a bid when markets are selling off and an offer when markets are well bid – while swap-dealer trading is uncorrelated with price volatility.9 Knittel and Pindyck (2016) found speculation has reduced volatility in prices since 2004, including during the 2007-08 price run-up.10 Using a straightforward supply-demand-inventory model, they examined cash and storage markets to determine whether speculation had any effect on them or on convenience yields based on cash-vs-futures spreads. They concluded: "We found that although we cannot rule out that speculation had any effect on oil prices, we can indeed rule out speculation as an explanation for the sharp changes in prices beginning in 2004. Unless one believes that the price elasticities of both oil supply and demand are close to zero, the behavior of inventories and futures-spot spreads are simply inconsistent with the view that speculation has been a significant driver of spot prices. If anything, speculation had a slight stabilizing effect on prices." Investment Implications Assuming the UK remains a bellwether for DM economies with reasonably effective vaccine programs, or which have experienced an omicron surge, markets could be close to exiting the COVID-19 pandemic and entering a phase in which the coronavirus is endemic. This would be bullish for demand. And given the extended tightness on the supply side for industrial commodities in particular, it could presage another leg up in prices as economic normalcy returns. We continue to favor broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index.   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 LNG baseload and peak liquification capacity is expected to rise ~ 13% this year to 11.4 Bcf/d and 13.8 Bcf/d (on a December-to-December basis), based on the EIA's latest estimates. The agency's forecast for LNG exports is up 17.3% to 11.5 Bcf/d this year, and 12.1 Bcf/d in 2023. With these increases in baseload and peak export capacity, the US is set to become the largest exporter of LNG in the world this year, in the EIA's estimation. This will be integral to US foreign policy, particularly in markets where the US competes with Russia for export sales, in our estimation. Within North America, US pipeline gas exports to Mexico and Canada are expected to average just under 9 Bcf/d this year, a 5% increase vs. 2021, and 9.2 Bcf/d in 2023. Base Metals: Bullish In China, seasonally low production, as stainless-steel firms undergo maintenance, and the upcoming Winter Olympics in February are keeping steel production subdued. To compound this supply shortage, tight raw material markets, particularly that of iron ore and nickel are buoying steel prices. Heavy rainfall in southern-eastern Brazil is curtailing iron ore production in the region. After Australia, Brazil is the second largest iron ore exporter to China. Nickel prices hit a 10-year high on Tuesday on the back of falling inventories. An LME outage also precipitated the price rise. Dwindling inventories point to increasing demand for the metal as electric vehicle companies ramp-up production and sales this year, particularly in China, where the government stated it will remove EV subsidies by the end of 2022. According to The China Passenger Car Association, EV sales in the country will double to 6 million this year. Precious Metals: Bullish Based on the December FOMC minutes, the markets are now pricing in a more hawkish tilt from the Fed, and expect an initial rate hike by March. The Fed may also shrink its balance sheet soon after the initial rate hike, in line with its expectation the U.S. economy will recover faster this time around. While higher nominal interest rates and tighter monetary policy will increase the opportunity cost of holding gold (Chart 8), the commodity-driven inflation we expect this year – especially if COVID-19 becomes endemic across major economies – will buoy demand for the yellow metal as an inflation hedge. An endemic virus this year will also boost physical gold demand from China and India. Chart 8       Footnotes 1     Please see More Commodity-Led Inflation On The Way, which we published on 9 December 2021. 2     Please see Coronavirus (COVID-19) latest insights: Antibodies, published by the ONS on December 23, 2021. 3    Please see Covid-19: UK ‘closest of any country in northern hemisphere to exiting pandemic’, published on January 11, 2022 by msn.com. 4    Please see What four coronaviruses from history can tell us about covid-19, published by newscientist.com on April 29, 2020. 5    Please see Omicron may be headed for a rapid drop in US and Britain, published by msn.com on January 11, 2022 published by msn.com. 6    Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. 7     We ran cointegrating regressions – using DOLS and ARDL models – to check for any equilibrium between prices and hedge fund positioning and found none. We looked at the post-GFC period from 2010 to now, since this is the data the US Commodity Futures Trading Commission (CFTC) provides for hedge funds and tested whether hedge-fund positions (in the form of open interest) explained prices vs. the alternative (i.e., prices explain hedge-fund positioning). We again found prices explain position (and not vice versa) for crude oil, natural gas, copper and gold. 8    Please see Büyüksahin, Bahattin and Jeffrey H. Harris (2011),"Do Speculators Drive Crude Oil Futures Prices?" The Energy Journal, 32:2, pp. 167-202. This paper used unique data sets provided by the CFTC. 9    Please see Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), "Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74. 10   Please see Knittel, Christopher R. and Robert S. Pindyck (2016), "The Simple Economics of Commodity Price Speculation," American Economic Journal: Macroeconomics 8:2, pp. 85–110. Investment Views and Themes Strategic Recommendations Trades Closed In 2021 Image