Commodities & Energy Sector

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

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

Next week is the BCA Annual Conference, at which I will debate Professor Nouriel Roubini on ‘The Outlook For Cryptocurrencies’. I will make the passioned case for cryptos, and Nouriel will make the passioned case against. I do hope that many of you can join the debate, as well as the other insightful sessions at the conference. As such, there will be no report next week and we will be back on October 28. Highlights The anomaly of the current ‘inflation crisis’ is not that goods and commodity prices have surged. The anomaly is that state intervention protected services prices from a massive (and continuing) negative demand shock. Absent the state intervention, there would not be the current ‘inflation crisis’. On a 6-12-month horizon: Underweight the durables-heavy consumer discretionary sector versus the market. Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Fractal analysis: Natural gas, plus industrial metals versus industrial metal equities. Feature Chart of the WeekServices Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Chart of the Week...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? The great writers, artists, and musicians tell us that the most profound messages often come from what is not said, not painted, and not played. What does not happen is sometimes more significant than what does happen. In this vein, we believe that the real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. The real story is that while goods and commodity prices have reacted exactly as would be expected to a positive demand shock, services prices have not reacted as would be expected to the mirror-image negative demand shock. The Anomaly Is Not Goods Prices, It Is Services Prices The following analysis quantifies the impact of the pandemic on different parts of the economy by examining the deviations of current spending and prices from their pre-pandemic trends. The analysis uses US data simply because of its timeliness and granularity, but the broad patterns and conclusions apply equally to most other developed economies. Looking at the overall economy, we know that, thus far, we have experienced neither a lasting negative demand shock from the pandemic, nor a lasting positive demand shock from the ensuing stimulus. We know this, because current spending is not far short of its pre-pandemic trend. The real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. Yet when we drill down to the components of spending, we see a different story. The pandemic and its policy response unleashed a massive and unprecedented displacement of spending from services to goods (Chart I-2). Chart I-2The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods By March 2021, while US spending on services was still below its pre-pandemic trend by $700 billion, or 8 percent, the displacement of those dollars of spending had boosted spending on the smaller durable goods component by 26 percent. Suffice to say, a 26 percent excess demand for durable goods cannot be satisfied by a modern manufacturing sector that utilises just-in-time supply chains and negligible spare capacity! As surging demand met relatively fixed supply, the price of durable goods skyrocketed to the current 11 percent above its pre-pandemic trend (Chart I-3). Chart I-3The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational It follows that the inflation in durables prices is the perfectly rational outcome of a classic positive demand shock – meaning, surging demand in the face of limited supply. What is much less rational is that a massive negative demand shock for services has had almost no negative impact on services prices. This is the untold story of the current ‘inflation crisis’ which requires further explanation. Government Intervention Prevented A Collapse In Services Prices If the pandemic had unleashed a classic negative demand shock for services, then services prices would have collapsed. We know this because in the aftermath of the global financial crisis (GFC), services prices fell below their pre-GFC trend exactly in line with the decline in services demand. But in the aftermath of the pandemic’s massive negative shock for services spending, services prices have remained on their pre-pandemic trend (Chart of the Week). The question is, how? The answer is that this was not a classic negative demand shock. The reason that service spending collapsed was that a large swathe of services – such as leisure and hospitality – became unavailable because of mandated shutdowns or lockdowns. In this case, there was no point in reducing prices to reattract demand from durable goods because nobody could buy these services anyway! In effect, while the goods sector remained subject to market forces, a large swathe of the service sector came under state intervention, and was no longer subject to market forces. Meanwhile, statisticians continued to record the seemingly unaffected price of eating out or going to the theatre, even though most restaurants and entertainment venues were shuttered, making their prices meaningless. Absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. Absent state intervention, these service providers would have had to reduce their prices to attract wary consumers amid a pandemic. This we know from Sweden, the one major economy that did not have any mandated shutdowns or lockdowns. While leisure and hospitality have remained largely open, Sweden’s services prices have declined markedly from their pre-pandemic trend – in sharp contrast to the unchanged trend in the US (Chart I-4). Chart I-4Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Hence, while inflation now stands at a sedate 2 percent in Sweden, it stands at a hot 5 percent in the US. If the US (and other country) governments had not intervened in the services sector, then the evidence from the GFC in 2008 and Sweden today strongly suggests that services prices would be below their pre-pandemic trend, offsetting goods prices that are above their pre-pandemic trend. The result would be that the overall price level would be on, or close to, its pre-pandemic trend. Just as overall spending is on its pre-pandemic trend. To repeat the key message of this analysis, the anomaly in most economies is not that goods and commodity prices have surged. The price surge is the perfectly rational response to a positive demand shock. The anomaly is that services prices did not react negatively to a negative demand shock (Chart I-5 and Chart I-6), as they did post-GFC and post-pandemic in non-interventionist Sweden. Chart I-5The Anomaly Is Not That Goods Prices ##br##Rose... The Anomaly Is Not That Goods Prices Rose... The Anomaly Is Not That Goods Prices Rose... Chart I-6...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall The untold story is that, absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. What Happens Next? The surging demand for durables is correcting. Since March, it is already down by 15 percent but requires a further 7 percent decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own! Meanwhile, as manufacturers respond with a lag to recent high prices, expect a tsunami of durables supply to hit in 6-12 months just as demand has fallen off a cliff. The result will be a major threat to any durable good or commodity price that has not already corrected. As a salutary warning of what lies ahead, witness the recent 75 percent crash in lumber prices. The same principle applies to non-durables such as food and energy. Non-durables spending is likely to fall back to its pre-pandemic trend, and non-durables prices are likely to follow. Again, outside a short-lived surge in demand from, say, a very cold winter, there is only so much energy and food that you can consume. For services, there are two opposing forces. The inflationary force is that the recent inflation in goods will transmit into wages and therefore into services prices. Against this, the deflationary force is that structural changes, such as hybrid home/office working, mean that services spending will struggle to make the near 6 percent increase to reach its pre-pandemic trend. Underweight the durables-heavy consumer discretionary sector versus the market. Pulling these effects together, we reiterate three investment recommendations on a 6-12 month horizon: Underweight the durables-heavy consumer discretionary sector versus the market (Chart I-7). Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Chart I-7As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms Natural Gas Prices Are Technically Extreme The surge in natural gas prices in both Europe and the US has reached a point of extreme fragility on its 130-day fractal structure. Hence, if the tight fundamentals show the slightest signs of abating, natural gas prices would be vulnerable to a sharp reversal (Chart I-8). Chart I-8Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Elsewhere, we see an arbitrage opportunity between industrial metal prices, which are still close to highs, and industrial metal equities, which have plunged by 20 percent since May. The relationship between the underlying metal prices and the metals equities sector is now stretched versus its history, and on its composite 65/130-day fractal structure (Chart I-9). Chart I-9The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched Hence, the recommended trade is to go short the LMEX Index/ long nonferrous metals equities. One way to implement the long side of the pair is through the ETF PICK. Set the profit target and symmetrical stop-loss at 8 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area 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 surge in European natural gas prices is a consequence of China’s effort to wean itself off its coal addiction and of the energy supply problems around the world. As long as the energy price surge does not threaten a policy response by the ECB, it will not plunge Europe into a significant downturn. So far, the ECB is unlikely to respond, because a wage-inflation spiral has not developed. Natural gas prices will decline significantly over the coming months, as a result of the Nord Stream 2 pipeline and other developments around the world; thus, the energy price shock will not spill over into a durable inflation wave across the continent. Without a significant risk of premature monetary tightening, European cyclical assets will perform well over the coming 18 months. EUR/USD will stabilize in the 1.15-1.12 zone, and peripheral bonds will continue to outperform the core. Feature Europe is amidst an unprecedented energy crisis, following the past three months’ 235% and 240% increases in natural gas prices in the UK and the Netherlands’ benchmarks, respectively. Investors now begin to fear that this energy crunch will threaten the European economic recovery and could even plunge Europe into a renewed recession. Underlying inflation must rise enough to prompt a hawkish monetary policy response for the energy price spike to topple the economy. Higher energy prices alone will not be enough. Despite the current panic, more supply will make its way to Europe. Future prices are skewed to the downside from here. As a result, investors should refrain from betting on a rapid removal of monetary accommodation from the ECB. Additionally, an end to the energy crisis will allow the euro to recover and will help European cyclical assets. A Multifaceted Crisis The extraordinary spike in European energy and electricity prices reflects a rare confluence of events. Chart 1China's Wean Off From Coal China's Wean Off From Coal China's Wean Off From Coal First, China’s intake of natural gas is surging because of two decisions made by Beijing. The Xi Jinping administration is fighting aggressively to improve air quality in the country, because pollution is one of the population’s main worries. As a result, China is aiming to curtail the role of coal (which today accounts for 63% of its electricity production) in its energy mix; coal production is not following electricity generation (Chart 1, top panel). Coal imports are not substituting for the lack of domestic supply growth. Instead, China has cut its intake of Australian coal dramatically (Chart 1, bottom panel) in response to tensions between the two nations. Natural gas is filling the gap. Second, the rest of the world is also voraciously absorbing natural gas. The Korean economy has greatly benefited from the global rebound in industrial activity, and Japan is increasingly re-opening, a result of its accelerating vaccination campaign. Latin America has become an unusual buyer of LNG. Low rainfalls in Brazil have caused hydro-power generation to be well under normal levels this summer. As a result, natural gas shipments were also called upon to fill this gap. Third, Europe’s investment in alternatives is facing difficulties. As Chart 2 highlights, the EU generates 26% of its electricity generation from renewables; wind accounts for 55% of this category. However, as BCA’s commodity strategists recently showed, wind power generated low levels of output last summer across the EU and the UK, which occasioned a scramble for natural gas and coal power generation.  This process forced Europe to bid up LNG prices to compete with China, which caused European natural gas inventories to fall below the seasonal range of the past five years (Chart 3). Chart 2Europe’s Reliance On Renewable The European Energy Crisis The European Energy Crisis Chart 3Low Nat Gas Inventories The European Energy Crisis The European Energy Crisis Chart 4There's A Reason Why Energy Is Not Attracting Capital There's A Reason Why Energy Is Not Attracting Capital There's A Reason Why Energy Is Not Attracting Capital Fourth, the lack of investment in the energy sector over the past seven years is slowing the supply response. Much of the blame for this phenomenon has been laid on rising ESG standards, which have disincentivized banks, insurance companies, and pension plans from putting money in the energy sector. This is only partially true. The main culprit behind this lack of investment is the poor return generated in the energy sector over the past twelve years, especially compared to the tech sector. As an example, in Europe, ASML surged by more than 5000% since March 6 2009, whereas Royal Dutch Shell rose 19% (Chart 4). The former naturally attracted significantly more capital than the latter. Fifth, utilities are fearing a cold winter and are trying to stock up natural gas ahead of the cold season. The US Climate Prediction Center assigns a 70% to 80% chance of a La Niña event this winter. La Niña is a complex weather pattern that results in colder surface temperatures in the Pacific Ocean; it often produces colder temperatures across much of Western and Northern Europe. The effort to shore up depressed inventory levels ahead of this potential threat increases the pressure on natural gas prices. Bottom Line: The surge in European natural gas prices reflects a confluence of unusual forces. China is trying to move away from polluting coal electricity generation, while global demand has been buoyed by the re-opening of the economy and exceptional weather patterns. Moreover, the supply response of the energy sector is tepid following seven years of low capital investment because of low rates of returns. To add insult to injury, EU CO2 emission allocation prices reached a record of EUR64.3/ton in September, which adds to the pressure on electricity prices created by record natural gas prices. From Energy Crunch To Recession? This rapid climb in energy prices is bound to affect European economic activity in the fourth quarter as some firms must curtail production. However, important counterbalances will limit this pain. Hence, on its own, the energy crisis is unlikely to cause a major slowdown or recession. Natural gas, oil, and coal consumption only represent a small share of output at 2% of GDP, or the lowest level since 1999 (Chart 5). If we assume that all energy prices average their 2008 peaks for the next 12 months, the energy spending as a share of GDP will hit 5%, still below the 2008 apex. We do not believe average energy prices will be that high for that long (see European Nat Gas Prices Have Downside section). Thus, while the current energy prices surge is painful for many, the effective tax on the overall European economy remains manageable. Robust income expansion compensates for this small growth-tax increase. The Eurozone Gross National Income is rebounding smartly since its Q2 2020 trough. Exports outside the Eurozone are near all-time highs, and the goods and services balance of the current account is strong (Chart 6). Chart 5Energy Spending Is Small The European Energy Crisis The European Energy Crisis Chart 6Offsets To Rising Energy Costs Offsets To Rising Energy Costs Offsets To Rising Energy Costs Chart 7Resilient Confidence Resilient Confidence Resilient Confidence Confidence surveys remain unphased by the tumult in the energy market. The European Commission Consumer and Business Confidence Surveys stand near 3- and 14-year highs, respectively (Chart 7, top panel). The Belgian Business Confidence Survey, which historically acts as a bellwether for the whole of Europe, still stands near its all-time high. Even more surprising, the retail sales survey continues to climb higher (Chart 7, second panel). In Germany, which is historically sensitive to energy prices, the Ifo Business Climate index is remarkably stable (Chart 7, third panel). Even Italy, which is exceptionally reliant on natural gas, is resilient: Consumer confidence hit a ten-year high, and business confidence remains close to its recent record (Chart 7, bottom panel). Fiscal policy is creating another important offset to higher energy prices. Underlying government deficits are tabulated to decrease from 3.8% of GDP for the Eurozone in 2020 to 3.6% in 2021 and 1.5% in 2022. However, this is happening as private sector savings decline rapidly, the result of the re-opening of the economy and robust confidence. Instead, what matters is that the deficit will remain large by historical standards and is creating more aggregate demand than in the pre-pandemic period (Chart 8). Moreover, the NGEU funds will spend an envelop worth EUR750 billion, mostly for vulnerable economies, such as Italy or Spain. Ultimately, it requires more than just rising energy prices to prompt an economic contraction. The US provides an interesting example. As Chart 9 illustrates, when previous sharp increases in commodity prices were associated with a rapid tightening in monetary policy, a recession followed. This time around, monetary policy is looking through the surge in input prices, because global central bankers firmly believe that the recent increase in inflation is transitory. Similarly, because credit spreads remain very narrow, equity prices remain elevated, and global bond yields are still very low, global financial conditions will remain extremely accommodative. Thus, if inflation does not broaden and central bankers do not panic, growth will turn out to be fine. Chart 8No More Budget Surpluses The European Energy Crisis The European Energy Crisis Chart 9Higher Commodity Prices Alone Won't Cause A Recession Higher Commodity Prices Alone Won't Cause A Recession Higher Commodity Prices Alone Won't Cause A Recession Bottom Line: The European energy crisis is causing investors to worry, and many now fear that a major slowdown or even another contraction in output is in the offing. However, carbon-based energy represents too small a share of GDP to cause such a dire outcome, especially when income growth remains strong, confidence is elevated, and fiscal policy is broadly accommodative. Ultimately, the reaction of central bankers will determine the outlook for economic activity. Will The ECB Respond To Inflation? The hurdle is very high for the ECB to respond to the recent increase in HICP to 3.4%. To begin with, the ECB is still reeling from its decision to lift the repo rate twice, to 1.5% in 2011 when HICP reached 3% on the back of strong energy prices (Chart 10). This decision is now widely considered a policy mistake that accentuated the European sovereign debt crisis. Beyond a fear of repeating history, the ECB is constrained by the narrow nature of European inflation. As Chart 11 shows, trimmed mean CPI, which includes 84% of the consumer prices index components, remains extremely depressed by historical standards, highlighting the role of a few components in driving up overall inflation. Moreover, shelter inflation remains a tepid 1.1%. Hence, the surge in CPI reflects higher commodity prices and base-effects from the pandemic. Chart 10The 2011 Mistake The 2011 Mistake The 2011 Mistake Chart 11Inflation Is Still Narrowly Based Inflation Is Still Narrowly Based Inflation Is Still Narrowly Based Wage dynamics will determine when energy prices will cause a broad-based increase in inflation. Without significantly higher wage growth, higher energy prices are a relative price shock that saps spending in other areas. For now, the de-linking of Bund yields and European energy prices confirms we are still facing such a price shock (Chart 12, top panel). Trends in hourly earnings and negotiated wages are currently also inconsistent with generalized inflation (Chart 12, second and third panel). Obviously, the situation may change. It will require a large adjustment in expectations. For now, European inflation expectations are trending higher, but they remain mostly a function of dynamics in the energy market (Chart 13, top panel). Similarly, the fluctuations in energy prices strongly influence the perception of firms about their ability to raises prices (Chart 13, bottom panel). Chart 12A Relative Price Shock, Not Generalized Inflation A Relative Price Shock, Not Generalized Inflation A Relative Price Shock, Not Generalized Inflation Chart 13Inflation Expectations Will Follow Energy Prices Inflation Expectations Will Follow Energy Prices Inflation Expectations Will Follow Energy Prices Ultimately, energy price inflation must remain elevated for several more months before inflation expectations become permanently unhinged. Thus, if energy prices stabilize or decrease in the new year, then no wage-inflation spiral will develop, and the ECB will not lift policy rates and prompt a severe slowdown in economic activity. Bottom Line: Due to the memory of the 2011 policy mistake and the lack of broad-based inflationary pressures in Europe, the ECB will continue to ignore the rise in headline inflation. However, if energy price increases perdure long enough, inflation expectations and wages will become problematic. Only in this context will the ECB tighten policy and prompt a severe slowdown. European Nat Gas Prices Have Downside We expect European natural gas prices to decline significantly over the coming months, which will prevent the ECB from tightening policy too early and cause a significant growth slowdown. The opening of the Nord Stream 2 pipeline early next year is a game changer. German regulators still have to announce whether to allow deliveries to flow to the domestic market, but Russia is already filling the pipeline completed last month. Moreover, the German public widely supported the project in May (Chart 14), and the recent energy crunch must have only solidified this trend. Nord Stream 2 is key for another reason. Russia limited the inflow of gas to Europe ahead of the pipeline opening to improve its negotiation position and put pressure on Germany to accept the project. Most importantly, the IEA estimates that Russia has ample capacity to supply European gas markets, and the trend in Russian gas production remains healthy (Chart 15). Chart 14Broad-based Support For Nord Stream 2 The European Energy Crisis The European Energy Crisis Chart 15Nat Gas Production Profiles The European Energy Crisis The European Energy Crisis Outside of Russia, other gas producers will continue to ramp up production. Australia is becoming an increasingly important player in the global LNG market and its production is rising (Chart 15, second panel). Qatari production has been flat for nine years. However, recent permit auctions point toward a strong increase in production in the North Field, in the order of 40% by 2026, buttressed by $60 billion in capex from 2021 to 2025. Saudi Arabia, too, is expected to increase natural gas production from next year to 2025. Finally, US production is still expanding; the IEA expects this country to become the world’s largest LNG exporter by 2025. A large part of the fears about higher European natural gas prices over the coming months relate to La Niña. Investors understand full well that it could generate a cold winter and are focusing on this risk, which is already reflected in natural gas prices. However, La Niña also causes wetter winters in Brazil, which would allow a resumption of hydro-power generation in this market. Additionally, La Niña also results in unstable winter conditions in Northern Europe, which suggests that wind will increase; the latter would alleviate some of the problems linked to renewable power that have forced natural gas prices higher. The growth in LNG demand from Asia should also slow in the near term. China is committed to its shift away from coal-powered electricity production, but the inability to produce enough electricity has caused occasional blackouts and electricity rationing around the country. In response to these pressures, Chinese authorities have recently started to allow deliveries of Australian coal. Moreover, in Japan, Fumio Kishida, the recently elected head of the LDP, is a big supporter of nuclear energy, and he plans to re-open nuclear plants rapidly after becoming prime minister. Such a move would quickly decrease Japan’s appetite for LNG. Finally, Iran remains a wild card. Iran possesses the second largest natural gas reserves in the world after Russia and is the world’s third-largest producer. Europe currently cannot access that gas because of the US post-JCPOA sanctions. However, Israel and the US are now in favor of returning to the conditions of the JCPOA, which means that, if a deal is hastened, Iranian natural gas will find its way into the global market. While it is not a base case for 2021, it is a positive tail outcome that would have a large impact on the natural gas market and help Europe greatly. Bottom Line: European natural gas prices have likely already peaked or will do so soon. The Nord Stream 2 pipeline, which should begin deliveries this winter, is an important development, especially because Russia has the capacity to supply Europe adequately. Moreover, global production of natural gas is set to increase meaningfully over the coming years. While La Niña would result in lower winter temperatures in Europe, which boost demand, it would also help in terms of the supply of hydropower in Brazil and wind in Northern Europe; meanwhile, Japan looks set to restart nuclear power generation under a Kishida administration. Finally, both the US and Israel are warming up to a return to the JCPOA with Iran, which would result in a great increase in international supply. This last point is more a downside risk for natural gas prices than a factor we are banking on. Investment Implications We expect natural gas prices to depreciate over the coming months, and thus, the current shock will have little enduring impact on European economic activity. The lack of recession risk suggests that our 18-month preference for markets like Germany, Sweden, and small cap remains appropriate. It also means that the tactical window for Spain to outperform remains open. Peripheral spreads will also remain well behaved, and Italian, Portuguese, Greek, and Spanish bonds will outperform German and French bonds further. Without higher natural gas prices, inflation expectations will not become unanchored to the upside, and the ECB will maintain a very accommodative monetary policy. Not only will the ECB lag well behind the Fed in terms of increasing interest rates, it will also remain an active buyer of European bonds next year. We continue to be a buyer of EUR/USD in the 1.15-1.12 region. The ECB is unlikely to come to the rescue of the euro; however, tighter peripheral spreads, continued growth convergence with the US, and a rebound next year in global economic activity will help the common currency.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations The European Energy Crisis The European Energy Crisis Cyclical Recommendations The European Energy Crisis The European Energy Crisis Structural Recommendations The European Energy Crisis The European Energy Crisis Closed Trades The European Energy Crisis The European Energy Crisis   Currency Performance Fixed Income Performance Equity Performance

Highlights The DXY is sitting comfortably within our 94-95 range. A punch above this level will seriously challenge our bearish thesis. The biggest risk to our view is the outlook for global growth, which we believe will remain firm in 2022. Currency volatility will stay elevated in the near term, creating opportunities at the crosses. We are already positioned for this, with short EUR/NOK, long AUD/NZD, and long CHF/NZD positions as high-conviction trades. We were stopped out of our long silver and yen trades. We are standing aside on both for now, awaiting more clarity on the global macro outlook before reentering these positions. Feature Over the last few weeks, we have received significant pushback from clients on our bearish dollar view. In this report, we attempt to address some of the most common concerns. We will tackle other issues in future newsletters. Global Growth Is Peaking, Isn’t That Usually Dollar Bearish? It is true that global growth is peaking. But this is happening from levels well above trend. The global PMI currently sits at 54.1, within its 85th percentile over that last 20 years. Historically, when global growth has been this strong, the dollar declines on a year-on-year basis. Bloomberg estimates point to the US, euro area, Japan and China growing by 4.1%, 4.3%, 2.5%, and 5.5%, respectively, over the next year. These are very strong numbers that can only be torpedoed by a severe exogenous shock. When it comes to currencies, relative growth dynamics also matter. The strength in the US dollar this year has been driven by upbeat economic surprises in the US relative to its trading partners (Chart I-1). But evidence suggests that US growth is losing momentum compared to other countries. This can be seen via Bloomberg consensus growth forecasts, relative PMI indices, and other hard data. Chart I-1Relative Growth And The Dollar Relative Growth And The Dollar Relative Growth And The Dollar Chart I-2Euro Area Data: An Unsung Hero Euro Area Data: An Unsung Hero Euro Area Data: An Unsung Hero Let us take the example of the euro area. The market has already priced in that the ECB will never raise rates before 2025, while the probability of the Federal Reserve hiking interest rates twice next year is rising. With this as a backdrop, the leading economic indicator for the euro area has overshot indicators in the US, lending standards are very robust, and retail sales are gaining momentum relative to the US (Chart I-2). In a nutshell, while there is much pessimism priced into the euro (and other G10 currencies), upside surprises, either from economic data or ECB hawkishness, are not priced in. What About The Rising Risk Of Another Wave of COVID-19 ? This is a legitimate risk, given that we are learning new things about the virus every day. But the picture is much better today compared to the last 12 months. First, the number of daily new infections is peaking (Chart I-3). This is positive news for global growth as economies reopen. Second, the peak in new infections has been falling with every new wave. This suggests that as populations get vaccinated, the threat from new variants is ebbing.   Chart I-3ALower Infection Rates... Lower Infection Rates... Lower Infection Rates... Chart I-3B...As Populations Get Vaccinated ...As Populations Get Vaccinated ...As Populations Get Vaccinated Chart I-4The Case For Japan The Case For Japan The Case For Japan Consider Japan, which hosted the Olympics with less than 10% of its population vaccinated a month earlier: It now boasts a higher vaccination rate than the US and new infection rates are falling off a cliff. This raises the prospect for a coiled spring rebound in Japanese economic activity (Chart I-4). The same will apply to other countries with low vaccination rates. China Is Important For Global Growth, How Do You Calibrate The Risk Of A Meaningful Slowdown? China is clearly important for global growth, but our bias is that the market has overstated the scale of a property slowdown and the crackdown on technology behemoths. Chart I-5China Risks And The RMB China Risks And The RMB China Risks And The RMB As currency investors, it has been peculiar that the RMB has stayed resilient, despite carnage in the equity market (Chart I-5). The reason is that there are no meaningful outflows from China. This suggests that both foreign and local investors believe the authorities will successfully contain the risk of contagion. The Fed Is Turning More Hawkish, Do You Want To Fight The Fed? There is what the Fed says and how its actions measure up compared to other central banks. Let’s start with what the Fed has said. Half of the committee expects at least one interest rate hike in 2022, with 7 or 8 hikes by the end of 2024. The tapering of asset purchases will also begin at the next policy meeting and end towards the middle of next year, in time for rate increases. This has been a hawkish shift from the Fed, well priced by the bond and currency markets (Chart I-6). However, the Fed is lagging other central banks. On the other side of the ocean, both the Norges Bank and the Reserve Bank of New Zealand have already hiked interest rates by 25 bps. The Riksbank will end asset purchases this year. The Bank of England has currently  purchased £852bn of its £895bn target for government and corporate bonds, the Bank of Canada has already cut its asset purchases in half, and the Reserve Bank of Australia has been tapering asset purchases. Chart I-6Interest Rates And The Dollar Interest Rates And The Dollar Interest Rates And The Dollar Chart I-7Central Banks And Government Bonds Central Banks And Government Bonds Central Banks And Government Bonds Even assuming a terminal Fed fund rate of 2.5%, real interest rates will remain near zero for the US, which is running a massive balance of payments deficit. Meanwhile, within G10 central banks, the Fed has the least bloated balance sheet, providing room to stay relatively dovish (Chart I-7). Chart I-8A Snapshot Of Real Rate Addressing Client Questions Addressing Client Questions Inflation could hold the key to a Fed shift. Many central banks are withdrawing accommodation amidst inflation mandates that are near or above target. However, the Fed has telegraphed that it is willing to tolerate an inflation overshoot following downturns. Given our bias that the current inflationary pulse will subside, the Fed could  become more dovish compared to market expectations. This will keep real rates in the US depressed (Chart 8). The Dollar Is A Momentum Currency, Why Go Against The Trend? The momentum factor for the dollar works until it doesn’t. That is usually the case at extremes. The dollar was in a well-defined bull market from 2011 to 2020, underpinned by a clean upward-sloped trendline (Chart I-9). That trendline was broken in 2020, and we are now recovering from capitulation lows. This is occurring within a context where everyone is bullish the dollar. Net speculative longs in the dollar are as high as in 2017 and even 2020. Being a contrarian back then was rewarded, but the dollar staged meaningful declines (Chart I-10).  Chart I-9A Technical Profile For The Dollar A Technical Profile For The Dollar A Technical Profile For The Dollar Chart I-10A Bullish Consensus A Bullish Consensus A Bullish Consensus Over the longer term, the dollar tends to move in cycles of about a decade or so. During bear markets, countertrend rallies in the dollar are capped at around 4%-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-11). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-11Bear Market Rallies Are Not Unusual Bear Market Rallies Are Not Unusual Bear Market Rallies Are Not Unusual The Dollar Is Expensive, But Valuation Is A Poor Timing Tool. Why Should We Care In The Near Term? It is true that the dollar is expensive. Most PPP measures, both traditional as well as our in-house curated measure, show the dollar is overvalued by about 15% (Chart I-12). That said, we do agree that valuation in isolation is a poor timing tool for trading currencies. Chart I-12AThe Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-12BThe Dollar Is Expensive Addressing Client Questions Addressing Client Questions However, valuation needs to be considered in the proper context. Our base case is that global growth will stay robust, and will expand from the US to other countries that have had more severe lockdowns. That is a macro environment that is bearish for the dollar. We have also made the case that everyone is bullish USD, especially given its strong performance this year. In that sense, valuation usually becomes useful when you are going against the herd because it provides a margin of safety. In our report “A Simple Trading Rule For FX Valuation Enthusiasts,” we made the case that gains can be made trading FX purely on valuation grounds. Let’s Talk About Actual Performance: Your Yen And Silver View Have Been Offside. Are You Sticking To These Recommendations? For now, no. It is tough for either the yen or silver to rise when the dollar is strong. So, more accurately, our dollar view has been offside this year. Assuming global growth rebounds and policymakers stay relatively easy, silver will do well. The case for silver remains compelling. Almost every major economy has negative real interest rates. This is fertile ground for precious metals, including silver. While the odds are on the side of yields  creeping higher from current low levels, this will still be bullish for precious metals if driven by rising inflation expectations. Competition for the dollar is also rising, not only from a precious metals perspective, but from cryptocurrencies as well. On the yen, the starting point is that it is the cheapest G10 currency. It is also one of the most shorted.  It is interesting that investors are shorting the currency that has one of the highest real rates in the developed world. Both the DXY and USD/JPY tend to be positively correlated, but this correlation also shifts during crises, when the yen generally appreciates more than the dollar. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The US economy remains relatively robust: The ISM manufacturing index rose from 59.9 in August to 61.1 in September. While new orders were flat, prices paid surged from 79.4 to 81.2. ADP employment came in at 568K in September, versus expectations of a 430K increase. The US trade balance continues to deteriorate amidst robust domestic demand. The August balance was -$73.3bn, versus expectations of a -$70.8bn deficit. The US dollar DXY index rose by 0.3% this week. Risk sentiment is souring, and real rates have increased in the US relative to other countries. This should keep supporting the dollar in the near term. However, a rotation in growth from the US to other countries will pressure the dollar lower.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data was mixed: Core CPI rose from 1.6% to 1.9% in September. The Sentix investor confidence index fell sharply in October, from 19.6 to 16.9. PPI continues to inflate higher in the euro area. The August number was at 13.4% year-on-year. Retail sales in the euro area were disappointingly flat in August. The euro fell marginally fell by 0.3% week. Everyone already expects the ECB to stay dovish. Ergo, any upside surprises will be on inflation, that nudges the ECB towards a more hawkish stance or growth. We think the euro already embeds a lot of negative news, while upside surprises are not fully priced in. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been improving: Consumer confidence rose from 36.7 in August to 37.8 in September. Tokyo core CPI was inline with expectations, but the headline did print rise 0.3% year-on-year, well above consensus. Office vacancies in Tokyo continue to creep higher, now at 6.4% versus a low of under 2%. The yen fell 30bps this week. We were stopped out of our long yen position, but we remain bulls. In an environment where interest rates rise, the yen suffers. However, the yen is cheap and offers insurance against currency volatility. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was scant data out of the UK this week: Most measures suggest UK growth was robust in Q2. UK productivity growth rose in Q2, a welcome fillip for the currency. The pound rose by 1% this week. Sterling is well into oversold levels. This is happening amidst rising gilt yields. In our view, longer-term investors should be accumulating the pound on weakness. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data is improving: Terms of trade is robust, even taking into consideration the decline in iron ore prices. The trade balance improved in August from A$12bn to A$15bn. The RBA kept rates on hold at this week’s policy meeting. The AUD rose 1.2% this week. The AUD is due for a coiled spring rebound especially given the commodities it exports are in high demand. We are already long AUD/NZD, but outright long Aussie positions make sense given negative speculative positioning and a bombed-out technical indicator. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: House prices inflated 28% year-on-year in September. ANZ consumer confidence fell from 109.6 to 104.5 in September. The RBNZ lifted rated by 25bps. The NZD rose by 1% week. The RBNZ is one of the few central banks that considers house price appreciation in its monetary mandate. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced. As such, the kiwi could lag other commodity currencies. We are long AUD/NZD on this basis. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been robust: The Ivey Purchasing Managers Index rose sharply from 66 to 70.4 in September. The August trade balance rose from C$0.8bn to C$1.9bn. The Bloomberg Nanos Confidence index remains robust above 60. The CAD rose 1% this week. Strong oil prices and a relatively hawkish BoC bode well for the loonie. We expect the BoC to further telegraph interest rate hikes in its October meeting. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The Swiss economy is on the mend: September manufacturing PMI rose to 87.7 from 68.1 Core CPI came in at 0.9% in September, in line with expectations. The labor markets remains robust. The unemployment rate dropped from 2.7% in August to 2.6% in September. CHF rose by 0.3% this week. We are long CHF/NZD as a hedge against rising currency volatility. Improving swiss domestic conditions are an added catalyst to this view. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Norwegian data is consolidating at high levels: The DNB/NIMA manufacturing index fell from 62.2 to 59.2 in September. The unemployment rate came in at 2.4% in September, falling from 2.7% the prior month. Industrial production remains robust at 2.7% year-on-year. The NOK was up 1.9% this week. NOK benefits from high energy prices. We also continue to be bullish Scandinavian currencies as a cyclical play on a lower US dollar. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish economic data this week was robust: The Swedbank/Silf manufacturing PMI rose from 60.1 to 64.6 in September. On the service side, the Swedbank index increased from 64.7 to 69.6 in September. Both industrial production and household orders remain robust. The SEK fell 30 bps this week. The SEK is very sensitive to a bottoming in the Chinese credit impulse, which we believe will happen. Meanwhile, CPI will overshoot in Sweden, bringing forward expectations of tightening from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Footnotes Trades & Forecasts Forecast Summary Addressing Client Questions Addressing Client Questions Strategic View Addressing Client Questions Addressing Client Questions Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Closed Trades

Highlights Gold prices will continue to be challenged by conflicting information flows regarding US monetary policy; higher inflationary impulses from commodity prices and supply-chain bottlenecks; global economic policy uncertainty, and risks to EM economic growth (Chart of the Week). Concern over the likely tapering of the Fed's asset-purchase program this year, rate hikes next year and fiscal-policy uncertainty will support rising interest-rate risk premia and a stronger USD. These will remain headwinds for gold. Going into the Northern Hemisphere's winter, risk premia in fossil-fuel prices are at or close to their zeniths, as is the Bloomberg commodity index. This will keep short-term inflation elevated. Heightened geopolitical tensions – particularly between Western democracies and China – will keep the USD well bid by risk-averse investors. The commodity-induced element of PCEPI inflation will be transitory. Uncertainty over US monetary policy and rising geopolitical tensions, however, will remain part and parcel of gold fundamentals indefinitely. The trailing stop on our long 1Q22 natural gas call spread – long $5.00/MMBtu call vs. short $5.50/MMBtu call – was elected, leaving us with a 20% gain. We will not be re-setting the spread at tonight's close, due to the difficulty in taking a price view in markets with extremely high weather-related uncertainty. Feature The quality of information informing the analysis of gold markets is highly uncertain at present. US monetary policy uncertainty and the future of Fed chairman Jerome Powell keep expectations twitchy when it comes issues like the tapering of the Fed's asset-purchase program. Our colleagues at BCA's US Bond Strategy expect the Fed will announce a taper in asset purchases by November 2021 which will end in June 2022.1 But the tapering really is not, in our estimation, as big a deal as inflation and inflation expectations, which will drive the Fed's rate-hiking timetable. Chart of the WeekUncertainty Weighs On Gold Uncertainty Weighs On Gold Uncertainty Weighs On Gold The first Fed rate hike expected by our bond desk likely will come at the end of next year. Our colleagues expect the Fed will want to check off three criteria before increasing interest rates (Table 1). The inflation targets – actual and expected – already have been checked off, leaving the labor market's recovery as the only outstanding issue on our internal checklist. By December 2022, once the maximum employment criterion has been met, the Fed will commence with rate hike.2 Subsequent rate hikes will depend on inflation expectations. Table 1A Checklist For Liftoff Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold Uncertain Inflation Expectations The higher inflation that checks off our bond desk's list resulted from COVID-19-impacted services and tight auto markets (Chart 2). We also find evidence commodities feed into inflation expectations and realized inflation, both of which are key variables for the Fed (Chart 3). Transitory effects – chiefly supply-chain bottlenecks and a global scramble for coal, gas and oil – have lifted realized inflation in 2H21, and have taken the Bloomberg commodity index to record levels (Chart 4). Nonetheless, given the fundamental backdrop for the key industrial commodities – chiefly oil, gas, coal and base metals – the inflationary impulse from commodity markets could persist indefinitely into the future, in our estimation. In order to incentivize the investment in base metals needed to literally build out the renewable energy infrastructure, the grids that support it and the electric vehicles that will supplant internal-combustion-engine technology, higher energy and metals prices will be required for years.3 This will be occurring as the production of traditional energy sources – i.e., fossil fuels – winds down due to lower investment over the next 10-20 years. This also will result in higher and more volatile oil and gas prices. Chart 2Inflation Meets Fed Targets Inflation Meets Fed Targets Inflation Meets Fed Targets Chart 3Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations All of these real-economy factors will feed into higher inflation over time, which will present the Fed with difficult choices regarding monetary policy and interest rates. Chart 4Record Commodity Index Levels Record Commodity Index Levels Record Commodity Index Levels USD Strength Suppresses Inflation And Gold Prices  It is worthwhile noting the current USD strength is suppressing inflation. However, it is not suppressing commodity prices entirely, as Chart 4 shows. The transitory weather-related price increases in energy commodities will pass, either when winter ends or if a less severe winter hits the Northern Hemisphere. We continue to expect a lower dollar, as the Fed's accommodative monetary policy remains in place. Even after the Fed tapers its asset-purchase program, policy will remain loose. The large fiscal packages that most likely will be approved by the US Congress will swell the US debt and budget deficits, which likely will weaken the USD over time. On a purchasing-power-parity basis (PPP) we also expect a weaker dollar (Chart 5). We also are expecting the availability of more efficacious vaccines in EM economies to boost economic activity, which will strengthen incomes and local currencies vis-à-vis the USD. Chart 5Weaker USD Expected On A PPP Basis Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold The risk to this USD view – which would support gold prices – remains the heightened geopolitical tensions between Western democracies and China, which will keep political uncertainty elevated and will keep the USD well bid by risk-averse investors. Persistent USD strength would restrain inflation, and weaken the case for owning gold. Investment Implications We remain bullish gold over the medium- and long-term, expecting higher inflation and inflation expectations to lift demand for this safe haven. However, persistent commodity-induced inflation could force the Fed to tighten monetary policy more than is currently expected to get out ahead of higher inflation and inflation expectations. This could lead to stagflation, wherein inflation runs high but growth stalls as interest rates move higher. Persistent geopolitical risk also will keep risk-averse investors well bid for the USD. Commodities Round-Up Energy: Bullish First-line US natural gas prices were down ~ 9% as we went to press, following reports Russia would make more gas available to European buyers. This report apparently was later contradicted by a Gazprom official, who said Russian inventories still were being filled ahead of winter.4 WTI crude oil prices came close to hitting a seven-year high early in the trading day Wednesday, then promptly retreated (Chart 6). The news flow is indicative of the extreme sensitivity of gas and oil buyers going into the coming winter. Base Metals: Bullish Earlier this week, the Peruvian government struck an deal with MMG Ltd, owner of the Las Bambas mine, and the local community around the site, which reportedly will involve hiring local residents to provide services to the mine, including helping transport minerals and maintaining key transit roads. The community had been protesting to seek more of the income from the mine, and created blockades en route to the site, which threatened ~ 2% of global copper supply. Peru's newly elected president, TK Castillo, rose to power on the promise to redistribute mining wealth to Peruvian citizens. This was his first negotiation with a mining company since his election in July. MMG’s major shareholder is China Minmetals Corp. The Leftist president will need to balance the interests of local stakeholders on the one hand, while ensuring the world’s second largest copper producing nation is still attractive to international miners. Precious Metals: Bullish In 2021, the World Platinum Investment Council expects the platinum to swing to a physical surplus of 190k oz, which reverses an earlier forecast for a deficit made in the Council's 1Q21 report (Chart 7). Demand is forecast to increase year-over-year, spurred by increases in automotive, industrial and jewelry demand. On the supply side, growth in South Africa's mined output growth will keep markets in a surplus for 2021. According to SFA Oxford, gross palladium demand and refined supply for 2021 are expected to be at 10.03mm oz, and 6.77mm, respectively. Palladium balances (ex-ETFs) are projected to remain in a physical deficit of 495k ounces for 2021. Chart 6 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 7 Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Footnotes 1     Please see Damage Assessment, published by BCA Research's US Bond Strategy on September 28, 2021. 2     Please see 2022 Will Be All About Inflation, published by BCA Research's US Bond Strategy on September 14, 2021, which notes the concept of maximum employment is not a well-defined term. 3    Please see La Niña And The Energy Transition, which we published last week. 4    Please see Energy price surge sends shivers through markets as Europe looks to Russia published by reuters.com on September 6, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Highlights Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched The Cotton Is Stretched The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area 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 ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations