Commodities & Energy Sector

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 Chart I-2Euro 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... Chart I-3B...As Populations Get Vaccinated Chart I-4The 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 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 Chart I-7Central 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 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 Chart I-10A 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 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 Chart I-12BThe Dollar Is Expensive 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 Chart II-2USD 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 Chart II-4EUR 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 Chart II-6JPY 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 Chart II-8GBP 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 Chart II-10AUD 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 Chart II-12NZD 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 Chart II-14CAD 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 Chart II-16CHF 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 Chart II-18NOK 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 Chart II-20SEK 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 Strategic View 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 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 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 Chart 3Commodities 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 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 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 Chart 7   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 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 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 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 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 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 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 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 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 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 Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations      

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, October 7 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth has peaked, but at very high levels. Progress on the vaccination campaign, along with continued accommodative monetary and fiscal policies, should keep recession risks at bay for the foreseeable future. Global Asset Allocation: Remain overweight stocks. While the risk-reward profile for equities is not as appealing as it was last year, the TINA theme (“There Is No Alternative” to equities) will continue to resonate with investors. Equities: Favor cyclicals, small caps, value stocks, and non-US equities. Long EM is an attractive contrarian play. Fixed Income: Maintain slightly below average interest-rate duration exposure. The US 10-year Treasury yield will rise to 1.8% by the first half of next year. Spread product will continue to outperform high-quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. The Canadian dollar will be the best performing DM currency during the remainder of the year. Commodities: Oil prices will remain firm, bucking market expectations of a decline. Metals may be at the cusp of a new supercycle. I. Macroeconomic Outlook Global Growth To Remain Above Trend Global growth has peaked, but at very high levels. According to Bloomberg consensus estimates, real GDP in the G7 rose by 6.0% in Q3, down from 6.8% in Q2 (Table 1). G7 growth is expected to soften to 4.9% in Q4, mainly reflecting somewhat softer growth in Europe following a blistering third quarter which saw real GDP expand by more than 9% in the UK and the euro area. Table 1Global Growth Will Remain Above Trend Well Into Next Year Not all countries have reached peak growth. Japan is projected to see faster growth in Q4, with GDP rising by 3.8% compared to 1.6% in Q3. Canadian growth should pick up from 4.5% in Q3 to 5.8% in Q4. Australia’s economy is projected to grow by 7.4% in Q4 after having contracted by 10.7% in Q3. Chinese growth is expected to accelerate to 5.9% in Q4 from 2.6% in Q3. Across almost all the major economies, growth should remain at an above-trend pace in 2022. G7 growth is expected to hit 4.1%, well above the trend rate of 1.4%. Usually when growth peaks, investors start to worry that a recession is around the corner. Given that growth is coming down from exceptionally high levels, this is not a major risk at the moment. Most Countries Are Easing Lockdown Restrictions Ten months after the first Covid vaccines became publicly available, 3.5 billion people, or 45% of the world’s population, have received at least one shot (Chart 1). At this point, most people in developed economies who want a vaccine have been able to receive one. Chart 1Nearly Half Of The World's Population Has Received At Least One Covid Vaccine Shot While vaccine availability in many emerging markets remains a problem, the situation is improving rapidly. India is currently vaccinating 7.5 million people per day. Over 45% of Indians have had at least one shot, something that would have seemed unfathomable just a few months ago. New medications are on the way. Just today, Merck announced a breakthrough pill that lowers the risk of hospitalization from Covid by 50%. Globally, the number of new daily cases has fallen from over 650,000 in August to 450,000 today. Lower case counts, along with increased vaccinations, have allowed most countries to loosen lockdown measures. Goldman’s Effective Lockdown Index has eased to the lowest level since the start of the pandemic (Chart 2). Chart 2Covid Restrictions Are Easing In Many Places Monetary Policy: The Slow March To Neutral As the pandemic recedes from view, central banks are starting to dial back monetary support. Last week, Norway became the first major developed economy to hike rates. New Zealand, having already ended QE, may raise rates before the end of the year. Other central banks are looking to normalize policy. The Bank of Canada has cut its asset purchases in half. The Reserve Bank of Australia has begun tapering asset purchases. The Swedish Riksbank has indicated that it will end asset purchases this year. The Fed will formally announce the tapering of asset purchases in November, while the Bank of England’s latest round of QE expansion will expire in December. The ECB, Swiss National Bank, and Bank of Japan remain firmly in the dovish camp. That said, the ECB has cracked open the exit door ever so slightly by announcing that it will stop buying assets through the Pandemic Emergency Purchase Programme in March (The ECB will continue to buy bonds under the existing Asset Purchase Programme, however). Taper Tantrum Redux? The prospect of Fed tapering has stoked worries of a replay of the 2013 Taper Tantrum. We think such worries are overstated. For one thing, tapering is not the same thing as tightening. The Fed will still be adding to the size of its balance sheet; it will simply be doing so at a diminished pace. Thus, tapering implies a slower pace of easing rather than outright tightening, a subtle but important distinction. Tapering could be regarded as tightening if, as in 2013, the very act of tapering sends a signal to investors that rate hikes are forthcoming. However, in the years following the Taper Tantrum, the Fed has gone out of its way to delink balance sheet policy from interest rate policy, stressing that the two are substitutes not complements.  The Fed is unlikely to start hiking rates until late 2022 or early 2023. It will probably take another year or two beyond then for interest rates to rise into restrictive territory, and even longer for the lagged effects of monetary policy to work their way through to the economy. There is an old saying: “Expansions don’t die of old age. They get murdered by the Fed.” The Fed will probably kill the expansion. However, the deed is unlikely to be committed until 2024 at the earliest, giving the bull market in stocks further scope to continue. Fiscal Policy: Tighter But Not Tight On the fiscal side, the IMF expects the aggregate cyclically-adjusted primary budget deficit in advanced economies to decline from 7.7% of GDP in 2021 to 3.7% of GDP in 2022, implying a negative fiscal impulse of 4% of GDP. Normally, such a negative fiscal impulse would weigh heavily on growth. However, since this fiscal tightening is set to occur against a backdrop of continued strong private domestic demand growth, the economic fallout should be limited. The absolute stance of fiscal policy also matters. While budget deficits will decline over the next few years, the IMF expects deficits to be larger in the post-pandemic period than they were before the pandemic (Chart 3). Chart 3Fiscal Policy: Tighter But Not Tight If anything, the IMF’s projections understate the likely size of future budget deficits as they do not incorporate any fiscal measures that have yet to be signed into law. These include the proposed $550 billion US infrastructure bill, an election-season stimulus package in Japan, and increased investment spending by what is likely to be a center-left coalition government in Germany. Chart 4Plenty Of Pent-Up Demand Perhaps one of the most important, and largely overlooked, consequences of the pandemic is that the bond vigilantes have been banished into exile. Governments ran record budget deficits last year and bond yields fell anyway. Post-pandemic fiscal policy is likely to end up being structurally more expansionary than it was following the Global Financial Crisis. Plenty Of Dry Powder It should also be noted that not all the stimulus funds that have been disbursed have made their way into the economy. US households are currently sitting on $2.4 trillion in excess savings, equivalent to about 15% of annual consumption (Chart 4). About half of these excess savings stem from decreased spending on services during the pandemic. The other half stem from increased transfer payments – stimulus checks, unemployment insurance benefits, and the like. Some investors have expressed concern that these savings will remain idle. Among other things, they note that a record high share of households in the University of Michigan survey think that this is a bad time to be purchasing big-ticket items (Chart 5). Chart 5Consumers Are Deferring Purchases Of Big-Ticket Items In Anticipation Of Lower Prices Chart 6Improving Consumer Confidence Will Buoy Consumption We would downplay these concerns. A review of the evidence from the original CARES act suggests that households spent about 40% of the stimulus checks within three months of receiving them. That is a reasonably high number considering that precautionary savings typically rise during times of economic uncertainty. Despite the improvements in the economy, consumer confidence remains below pre-pandemic levels. There is a strong correlation between consumer confidence and household consumption (Chart 6). As confidence continues to recover, household spending should hold up well. As far as the reluctance to buy big-ticket items is concerned, we would paint this in a positive light. When households are asked why they are not in a rush to buy, say, a new automobile, they answer, quite rationally, that they expect prices to fall and availability to improve. Concerns over job security are far down on the list. In this sense, the market mechanism is doing what it is supposed to do: Supplying goods to those who are willing to pay up in order to get them immediately, while giving those with a bit more patience the opportunity to buy them later at a lower price.  Chart 7Firms Will Need To Maintain High Production To Replenish Inventories From a macro perspective, this means that demand for durable goods is unlikely to fall off a cliff anytime soon. There is enough pent-up demand around to ensure production stays buoyant well into next year. This is especially the case for autos, where nearly half of US shoppers have decided to defer purchases. And with inventory levels at record lows, firms will need to produce more than they sell (Chart 7). It is difficult to see growth slowing dramatically in such an environment. Pandemic-Induced Inflation Spike Should Fade The willingness of households to postpone spending until supply has had a chance to catch up to demand should help mitigate inflationary pressures. It would be much worse if households thought that today’s high consumer goods prices presaged even higher prices down the road. Such a dynamic could easily unmoor inflation expectations, forcing the Fed into action. Despite the recent spike in inflation, household long-term inflation expectations have not increased that much. Inflation expectations 5-to-10 years out in the University of Michigan survey ticked up to 3% in September. While this is above the average level of 2.5% in 2017-2019, it is broadly within the range of expectations that prevailed between 1997 and 2014 (Chart 8). Chart 8Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Chart 9Wages At The Bottom End Of The Distribution Are Rising Briskly Chart 10Strong Wage Growth In The Leisure And Hospitality SectorWages have risen briskly at the bottom end of the income distribution (Chart 9). The jump in wage growth in the leisure and hospitality sector – where workers have been given the unenviable task of enforcing mask mandates and other requirements – has been particularly pronounced (Chart 10). However, wage growth for high-skilled salaried employees has been flat-to-down. As a consequence, overall wage growth, as measured by the Atlanta Fed Wage Tracker, has moved sideways. Rising CPI inflation remains contained to only a few categories. Median CPI inflation registered 2.4% in August, below where it was in late 2019. Excluding vehicle prices, the level of the core CPI remains below its pre-pandemic trend line (Chart 11). Chart 11Unwinding Of "Base Effects" Core Inflation With And Without Autos Recent indications suggest that used car prices have peaked (Chart 12). Memory prices are trending lower, suggesting that the worst of the semiconductor shortage may be behind us (Chart 13). The Drewry World Container Index also inched lower this week for the first time in five months. Chart 12Used Car Prices Have Peaked Chart 13Memory Chip Prices Are Edging Lower In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. II. Feature: The Real Risk From China’s Property Market Chart 14The Demographic Turning Point In Japan And China Lehman Moment Or Japan Moment? The turmoil surrounding Evergrande, one of China’s largest property developer, has sparked fears that China is experiencing its own “Lehman moment”. Such worries are misplaced. The Chinese government has enough control over the domestic financial system to keep systemic risks in check. The more appropriate analogy is not with Lehman, but with Japan. The Japanese property bubble burst in the early 1990s, sending the country into a prolonged deflationary funk. As was the case in Japan three decades ago, Chinese property prices are very high in relation to incomes. Moreover, as was the case in Japan, China’s working-age population has peaked, which is likely to translate into lower demand for housing down the road (Chart 14). As it is, studies using night light data suggest that 20% of apartments are sitting vacant. Similar to Japan, debt has fueled China’s housing boom. Chinese property developers are amongst the most leveraged in the world (Chart 15). Households have also been borrowing aggressively: Mortgage debt has risen from around 15% of GDP in 2010 to 35% of GDP (Chart 16). Chart 15Rising Leverage Ratios In China's Real Estate Sector Chart 16Mortgage Debt Has Been On The Rise In China Differences With Japan Despite the clear parallels between Japan in the early 1990s and China today, there are a number of key differences. First, Japan was already an advanced economy in the early 1990s. Today, labor productivity in China is still 40% of what it is in neighbouring South Korea (and 25% of what it is in the US). As productivity in China continues to rise, GDP will increase, even if the number of workers continues to shrink. As Chart 17 shows, China would need to grow by at least 6% per year over the next decade for output-per-worker to converge to South Korean levels by the middle of the century. It is easier to reduce leverage when incomes are growing quickly. Second, while real estate investment in China is still too high for what the country needs, it has been falling as a share of GDP since 2014 (Chart 18). This is not obvious from the monthly fixed asset investment data that investors track because this data counts land purchases as investment. Chart 17China: A Lot Of Catch-Up Potential Chart 18Chinese Real Estate Construction Peaked Years Ago   Property developers have been buying land and holding on to it in anticipation that it will appreciate in value. This carry trade will end, but the impact on the real economy may be limited if, as is likely, the assets of bankrupt property developers end up being shuffled into quasi state-owned entities, allowing existing housing projects to continue. After all, if the goal of the government is to make housing more affordable, stopping construction would be precisely the wrong thing to do. Third, China has learned from Japan’s policy mistakes, especially when it comes to the appropriate role for government stimulus in the economy. Japan’s biggest mistake in the 1990s was not that it failed to listen to western experts, but that it listened to them too much. The whole narrative about how Japan could have revived its economy through “structural reforms” never made any sense. Japan’s problem was not one of poor resource allocation; it was one of inadequate demand: The property sector collapsed, leaving a big hole in GDP that needed to be filled. Shutting down “zombie companies” arguably made things worse, not better. Chinese Stimulus On The Way Standard debt sustainability equations imply that paradoxically, a country with a high debt-to-GDP ratio can run a larger primary budget deficit than a country with a low debt-to-GDP ratio, while still achieving a stable debt-to-GDP ratio over time.1  In China’s case, bond yields are well below nominal GDP growth, which gives the government significant fiscal leeway (Chart 19). The Ministry of Finance has expressed its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. Increased bond issuance will allow local governments to trim their reliance on land sales to finance spending. For its part, the PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 20). With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. Chart 19Chinese Bond Yields Are Well Below Nominal GDP Growth Chart 20A Positive Sign For Credit Growth In China   Chart 21China Suffers From High Levels Of Inequality Rebalancing The Chinese Economy Over the long haul, China will need to encourage consumer spending in order to allow for the continued contraction of the construction industry without depressing overall employment. At 38% of GDP, China’s consumption share is one of the lowest in the world. A weak social safety net has forced Chinese households to maintain high levels of precautionary savings. Rampant inequality has shifted income towards richer households which tend to save more than the poor (Chart 21). Sky-high home prices only amplified the need to save more to buy a flat. All this has depressed overall consumption. For all its faults, President Xi’s “common prosperity” campaign could help redress all three of these problems, ultimately creating a stronger and more balanced economy. In summary, while China does represent a risk to the global economy, the threat at the moment is not severe enough to warrant turning bearish on equities and other risk assets. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Investors often express skepticism about the benefits of using macroeconomics as an input into their investment process. Charts 22 and 23 should dispel such doubts. The charts show that the business cycle is by far the most important driver of equity returns over medium-term horizons of 6-to-18 months. Chart 22The Business Cycle Drives Cyclical Swings In Stocks (I) Chart 23AThe Business Cycle Drives Cyclical Swings In Stocks (II) Chart 23BThe Business Cycle Drives Cyclical Swings In Stocks (II) For the most part, the change in the value of the stock market is closely correlated with the level of economic growth. As noted earlier, global growth is peaking but at very high levels. This suggests that stock returns will be reasonably strong over the next 12 months, although not as strong as they were over the preceding 12 months. Higher Bond Yields Unlikely To Undermine The Stock Market Treasury yields have moved up since the conclusion of the FOMC meeting on September 22nd. The market narrative of a “hawkish surprise” does not make much sense to us. The yield curve usually flattens after a central bank delivers a hawkish surprise. That is what happened following the June FOMC meeting. This time around, the 2-10 curve has steepened by 13 basis points. Our sense is that the rise in bond yields mainly reflects the lagged effect from the decline in Covid cases, along with the realization that the pandemic-induced rise in inflation may be a bit stickier than previously believed. Equities often suffer some indigestion when bond yields rise. However, history suggests that as long as yields do not increase enough to imperil the economy, stocks usually end up recovering and reaching new highs (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The 10-year Treasury yield has already risen halfway to our 2022H1 target of 1.8%. Any further upward move is likely to be more gradual than what has transpired over the past few weeks. As such, we expect the pressure on stocks to diminish. The fact that bearish sentiment in the AAII survey reached a one-year high this week suggests we may be nearing a bottom in stocks. Ultimately, TINA’s siren song will be impossible to resist. What Is The True ERP? While equity valuations are not cheap, they are not at extreme levels either. The MSCI All-Country World Index currently trades at 18-times forward earnings. Unlike in most years, analysts have been revising up earnings estimates this year, both in the US and abroad (Chart 24). This suggests the currently quoted forward PE ratios are not excessively optimistic. Chart 24Analysts Increased Earnings Estimates This Year Chart 25The Global Equity Risk Premium Is Elevated Relative to bonds, stocks still trade at a healthy discount. The forward earnings yield for the MSCI All-Country World index is 640 basis points above the global real bond yield (Chart 25). Even in the US, where valuations are more stretched, the implied equity risk premium (ERP) stands at 580 basis points. Amazingly, this is exactly where the US ERP stood in May 2008. The equity risk premium, as measured by the gap between the earnings yield and the real bond yield, will overstate the magnitude to which stocks are expected to outperform bonds if the PE ratio ends up falling over time. Nevertheless, for stocks to underperform bonds, PE multiples would need to fall by an implausibly large amount. For example, suppose US companies manage to grow real EPS by a modest 2.5% per year over the next decade. The US dividend yield is 1.3%. Assuming dividends rise in line with earnings, investors would receive a real total return of 3.8%. The 10-year TIPS yield is -0.9%. Thus, the US PE multiple would need to shrink by an average of 4.7% (3.8% plus 0.9%) per year over the next 10 years for stocks to underperform bonds on a real total return basis. This would take the US forward PE multiple down to 13. It is not unfathomable that the US PE multiple would fall this much. However, as a baseline scenario, it is too pessimistic. A more plausible baseline forecast would be a terminal PE multiple of 18. That would be consistent with a “true” ERP of 3%.   B. Equity Sectors, Regions, And Styles Favor Cyclicals, Value Stocks, And Small Caps As one might expect, cyclical equity sectors tend to outperform defensives in strong growth environments (Chart 26). The pandemic has exposed a shortage of industrial capacity across a wide range of industries from semiconductors to automobiles. US capital goods shipments have lagged orders for 18 straight months (Chart 27). Industrial stocks stand to benefit from increased capital spending. Materials and energy stocks will gain from strong commodity prices and a weaker US dollar (Chart 28). Chart 26Strong Growth Favors Cyclicals Chart 27US Capital Goods Shipments Have Lagged Orders   Chart 28Materials And Energy Stocks Will Gain From Strong Commodity Prices And A Weaker US Dollar Like cyclicals, value stocks do best during periods when global growth is strong and the US dollar is weak (Chart 29). Rising bond yields should help bank shares, which are heavily overrepresented in value indices (Chart 30). In contrast, tech shares, which are overrepresented in growth indices, usually struggle in rising yield environments. Value stocks are also cheap – three standard deviations cheap based on a simple composite valuation measure that compares price-to-earnings, price-to-book, and dividend yields (Chart 31). Chart 29Value Stocks Typically Do Well When The Dollar Is Depreciating Chart 30Higher Yields Are A Boon For Banks And A Bane For Tech   Chart 31Value Is Cheap Financials and industrials are overrepresented in US small caps indices, while tech and communication services are underrepresented (Table 3). Thus, it is not surprising that small caps usually outperform their large cap peers when growth is strong, the dollar is weakening, and bond yields are rising (Chart 32). Table 3Financials And Industrials Have A Larger Weight In US Small Caps Like value stocks, small caps are reasonably priced. The S&P 600 small cap index trades at 16-times forward earnings, compared to 17-times for the S&P 400 mid cap index and 21-times for the S&P 500 (Chart 33). Small cap earnings are also expected to grow by 30% over the next 12 months, easily beating mid caps (19%) and large caps (15%). BCA’s relative valuation indicator suggests that, compared to large caps, small caps are now as cheap as they were in the late 1990s (Chart 34). Chart 32US Small Caps Tend To Outperform When Growth Is Strong, The Dollar Is Weakening, And Bond Yields Are Rising   Chart 33US Small Caps Are Not Expensive Chart 34US Small Caps Are Attractive Relative To Large Caps Regional Equity Allocation: Better Prospects Outside The US Stock markets outside the US have more of a cyclical/value tilt (Table 4). Hence, they tend to fare best when global growth is strong and the dollar is weakening (Chart 35). Table 4Cyclicals Are Overrepresented Outside The US Chart 35Strong Growth And A Weaker Dollar Is Good For Non-US Stocks Probable tax changes could hurt the relative performance of US stocks. BCA’s geopolitical strategists expect the Democrats to raise the corporate tax rate from 21% to about 26%. Additional tax hikes are likely to apply to overseas earnings, something that will disproportionately affect tech companies. Non-US stocks are reasonably priced, trading at a forward PE ratio of 15. EM equities are especially cheap. They currently trade at a forward PE ratio of 13 (Chart 36). The EM discount to the global index is as large now as it was during the late 1990s. Chart 36AEM Equities Are Trading At A Large Discount (I) Chart 36BEM Equities Are Trading At A Large Discount (II) After a blistering period of rapid earnings growth during the 2000s, EM EPS has been trending sideways during the past decade (Chart 37). However, the combination of increased global capital spending and rising commodity prices should buoy EM profits in the years ahead. Improved performance from EM banks should also help. Chinese banks are trading at 4.2-times forward earnings, 0.5-times book, and sport a dividend yield of over 6% (Chart 38). Such valuations discount too much bad news. Chart 37AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade(I) Chart 37BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II)   Chart 38Chinese Banks: A Lot Of Bad News Is Discounted Chart 39Chinese Tech Stocks Underperformed Their Global Peers This Year Outlook For Chinese Tech Stocks The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 46% since February (Chart 39). Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 15.9-times 2021 earnings, Baidu is trading at 17.1-times earnings, and Tencent is trading at 27.1-times earnings. In comparison, the NASDAQ Composite trades at 31.9-times 2021 earnings.   C. Fixed Income Why Are Bond Yields So Low Even Though Inflation Is So High? While global bond yields have moved higher in recent days, they remain well below pre-pandemic levels. Investors are understandably puzzled about how today’s high inflation rates can coexist with such low bond yields. Two explanations stand out: First, despite the recent uptick in inflation expectations, investors still believe inflation will come down and stay down (Chart 40). In fact, the 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s comfort zone, suggesting that investors expect inflation to ultimately undershoot the Fed’s target. Chart 40AInvestors Expect Inflation To Fall Rapidly From Current Levels (I) Chart 40BInvestors Expect Inflation To Fall Rapidly From Current Levels (II) Chart 41The Market Thinks The Fed Will Raise Rates Only To 2% Second, and related to the point above, investors believe that the neutral rate of interest is very low. According to the New York Fed’s survey of market participants, investors think that the Fed will not be able to raise rates above 2% during the forthcoming tightening cycle (Chart 41). This is even lower than the terminal rate of 2.5% that the Fed foresees. When the Federal Reserve first introduced the dot plot back in 2012, it believed the neutral rate was 4.25%. If the neutral rate really is this low, then monetary policy is not as hyperstimulative as is often asserted. In that case, a 10-year yield of 1.5% would be entirely appropriate given that it will take a few years for rates just to reach 2%. Indeed, an even lower yield could be justified on the grounds that there is a high probability that the economy will be hit by an adverse shock over the next decade, requiring a return to zero rates and more QE. Maintain Below-Benchmark Duration Our view is that the neutral rate is higher than most market participants believe. The end of the household deleveraging cycle in the US, structurally looser fiscal policy, and the exodus of well-paid baby boomers from the labor market will all deplete national savings, pushing up the neutral rate of interest in the process. If a central bank underestimates the neutral rate, it is liable to keep interest rates too low for too long. This could cause inflation to rise more than anticipated, putting further upward pressure on bond yields. It will take some time for the market’s view to converge to our view (provided we are correct, of course!). Investors have bought into the secular stagnation thesis hook, line, and sinker. Thus, they will require plenty of evidence that the Fed can raise rates without strangling the economy. We expect the US 10-year yield to move to 1.8% by early next year, warranting a moderately below-benchmark duration stance. US Treasuries have a higher beta than most other government bond markets (Chart 42). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 42US Treasuries Have A Higher Beta Than Most Other Government Bond Markets Chart 43High-Yield Spreads Are Pricing In A Default Rate Of More Than 3% Corporate Bonds: Favor High Yield Over Investment Grade BCA’s bond strategists see more upside for high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 3.15% (Chart 43). This is more than their fair-value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.8%. Our bond team also sees USD-denominated EM corporate bonds as being attractively priced relative to domestic US investment-grade corporate bonds with the same duration and credit rating.   D. Currencies And Commodities Fade Recent Dollar Strength The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). The US dollar has strengthened in recent weeks, spurred on by a more cautious tone to markets (the VIX is around 22, up from 16 in late August). As risk sentiment improves, the dollar will weaken. The composition of global growth also matters. Growth momentum is rotating from the US to the rest of the world. The dollar usually struggles when this happens (Chart 45). Chart 44The Dollar Is A Countercyclical Currency Chart 45Growth Momentum Is Shifting Outside The US, Which Should Weigh On The Dollar Despite the uptick in US yields, short-term real rate differentials are heavily skewed against the dollar (Chart 46). The US trade deficit has surged over the past 16 months (Chart 47). Equity inflows have been financing the trade deficit, but these could tail off if US stocks start to lag their overseas peers. Chart 46Short-Term Real Rates Remain Skewed Against The Dollar Chart 47Widening Trade Deficit Is Dollar Bearish The US dollar remains pricey relative to its Purchasing Power Parity (PPP) measure of fair value (Chart 48). Speculators are also net long the dollar, making the dollar vulnerable to a positioning reversal (Chart 49). Chart 48The Dollar Is Expensive Based On PPP Chart 49Long Dollar Is Becoming A Crowded Trade Buy The Loonie Our favorite developed market currency going into the fourth quarter is the Canadian dollar. Unlike in most other major economies, Canadian growth has yet to peak. The Bank of Canada has been ahead of most other central banks in winding down QE and laying the groundwork for rate hikes. Chart 50Oil Prices To Remain Firm Firm oil prices should also help the loonie. One can be bullish on oil without expecting oil prices to rise very much. The oil curve is heavily backwardated (Chart 50). It suggests that the price of Brent will fall from $79 to $67 per barrel between now and the end of 2023. BCA’s commodity strategists expect the price of Brent crude to average $75 and $80 per barrel in 2022 and 2023, respectively, with WTI trading $2-$4/bbl lower. The RMB Will Hold Its Ground We doubt that China will weaken the RMB in order to stimulate the economy. China’s export sector is already operating at peak capacity. A weaker currency would do little to boost output. Geopolitical concerns will also keep the yuan from depreciating. The trade relationship between China and the US remains frosty. A weaker yuan would only make matters worse. Perhaps more importantly, China wants the RMB to be a global reserve currency. Weakening the RMB would run counter to that goal. A New Supercycle In Metals? China consumes over half the world’s industrial metals. Thus, fluctuations in the Chinese economy tend to drive metals prices. There is a very strong correlation between the Chinese credit impulse and industrial metals prices (Chart 51). If Chinese credit growth picks up over the coming months, this should support metals. Aside from iron ore, it is quite striking that most metals prices have remained firm this year even as China has cut back imports (Chart 52). Copper prices are up 45% year-over-year despite the fact that Chinese imports of copper are down 40% during this period. Chart 51A Pickup In Chinese Credit Will Bode Well For Metals Chart 52China Cut Back On Imports Of Commodities This Year     As in the early 2000s, the combination of a multi-year period of underinvestment in new mining capacity and new sources of demand could set the stage for an extended bull market in the metals complex. The shift to electric vehicles will boost demand for many metals. The typical electric vehicle uses four times as much copper as a typical gasoline-powered vehicle. Many pundits argue that because Chinese growth is slowing, China will not need as much commodities as in the past. However, this argument ignores the fact that China is slowing from a very high base. As Chart 53 shows, China consumes five times as much industrial metals as it did in the 2000s. In absolute volume terms, China’s incremental annual increase in metal consumption is twice what it was in the 2000s. Thus, Chinese demand is likely to support the commodity market for years to come. Gold Facing Crosswinds Gold prices tend to correlate closely with real interest rates (Chart 54). This is not surprising since the real yield can be regarded as the “opportunity cost” of holding a yield-less asset such as gold. Chart 53Chinese Consumption Of Commodities Ballooned Over The Past Three Decades Chart 54Gold Prices Tend To Correlate Closely With Real Interest Rates What is somewhat surprising is that gold prices have dipped more than one would have expected based on the evolution of real yields. The US 10-year TIPS yield is only slightly higher than where it was in early August 2020, when the price of gold reached $2,067 per ounce. Although it is difficult to be certain, the shift in investor interest from gold to cryptos has probably depressed gold prices. Both gold and cryptos are seen as “fiat money hedges”. Our expectation is that tighter regulation will imperil the cryptocurrency market, causing some funds to flow back into gold. Nevertheless, with real yields likely to edge higher over the coming years, the upside for gold prices is limited.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1  The steady-state debt-to-GDP ratio can be expressed as p/(r-g), where r is the interest rate, g is trend GDP growth, and p is the primary (i.e., non-interest) budget balance. Thus, for example, if the government wanted to achieve a stable debt-to-GDP ratio of 50% and r-g is -2%, it would need to run a primary budget deficit of 0.5*0.02=1% of GDP. However, if the government targeted a stable debt-to-GDP ratio of 200%, it could run a primary budget deficit of 2*0.02=4% of GDP. See Box 1 in our February 22, 2019 report for a derivation of this debt sustainability equation. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights The fourth quarter will be volatile as China still poses a risk of overtightening policy and undermining the global recovery. US political risks are also elevated. A debt default is likely to be averted in the end. Fiscal stimulus could be excessive. There is a 65% chance that taxes will rise in the New Year. A crisis over Iran’s nuclear program is imminent. Oil supply disruptions are likely. A return to diplomacy is still possible but red lines need to be underscored. European political risks are comparatively low, although they cannot go much lower, Russia still poses threats to its neighbors, and China’s economic wobbles will weigh on European assets. Our views still support Mexican equities and EU industrials over the long run but we are booking some gains in the face of higher volatility. Feature Our annual theme for 2021 was “No Return To Normalcy” and events have borne this out. The pandemic has continued to disrupt life while geopolitics has not reverted to pre-Trump norms. Going forward, the pandemic may subside but the geopolitical backdrop will be disruptive. This is primarily due to Chinese policy, unfinished business with Iran, and the struggle among various nations to remain stable in the aftermath of the pandemic. Chart 1Delta Recedes With Vaccinations Chart 2Global Recovery Marches On Chart 3Global Labor Markets On The Mend The underlying driver of markets in the fourth quarter will be the fact that the COVID-19 pandemic is waning as vaccination campaigns make progress (Chart 1). New cases of the Delta variant have rolled over in numerous countries and in US states that are skeptical toward vaccines. Global growth will still face crosswinds. US growth rates are unlikely to be downgraded further while Europe’s growth has been upgraded. However, forecasters are likely to downgrade Chinese growth expectations in the face of the government’s regulatory onslaught against various sectors and property sector instability (Chart 2). Barring a Chinese policy mistake, the global composite PMI is likely to stabilize. Labor markets will continue healing (Chart 3). The tug of war between unemployment and inflation will continue to give way in favor of inflation, given that wage pressures will emerge, stimulus-fueled household demand will be strong, and supply shortages will persist. Central banks will try to normalize policy but will not move aggressively in the face of any new setbacks to the recovery. Will China Spoil The Recovery? Maybe. Chinese policy and structural imbalances pose the greatest threat to the global economic recovery both in the short and the long run. The immediate risk to the recovery is clear from our market-based Chinese growth indicator, which has not yet bottomed (Chart 4). The historic confluence of domestic political and geopolitical risks in China is our key view for the year. China is attempting to make the economic transition that other East Asian states have made – away from the “miracle” manufacturing phase of growth toward something more sustainable. But there are two important differences: China is making its political and economic system less open and free (the opposite of Taiwan and South Korea) and it is confronting rather than befriending the United States. The Xi administration is focused on consolidating power ahead of the twentieth national party congress in fall 2022. Xi is attempting to stay in power beyond the ten-year limit that was in place when he took office. On one hand he is presenting a slate of socioeconomic reforms – dubbed “common prosperity” – to curry popular favor. This agenda represents a tilt from capitalism toward socialism within the context of the Communist Party’s overarching idea of socialism with Chinese characteristics. On the other hand, Xi is cracking down on the private sector – Big Tech, property developers – which theoretically provides the base of power for any political opposition. The crackdowns have caused Chinese equities to collapse relative to global and have reaffirmed the long trend of underperformance of cyclical sectors relative to defensives within Chinese investable shares (Chart 5, top panel). Chart 4China Threatens To Spoil The Party In terms of financial distress, so far only high-yield corporate bonds have seen spreads explode, not investment grade. But current policies force property developers to liquidate their holdings, pay off debts, and raise cash while forcing banks to cut bank on loans to property developers and homebuyers. (Not to mention curbs on carbon emissions and other policies squeezing industrial and other sectors.) Chart 5Beijing Could Easily Trigger Global Market Riot If these policies are not relaxed then property developers will continue to struggle, property prices will fall, credit tightening will intensify, and local governments will be starved of revenue and forced to cut back on their own spending. Yet the government’s signals of policy easing are so far gradual and behind the curve. If policy is not relaxed, then onshore equities will sell off (as well as offshore) and credit spreads will widen more generally (Chart 5, bottom panel). Broad financial turmoil cannot be ruled out in the fourth quarter. Ultimately, however, China will be forced to do whatever it takes to try to secure the post-pandemic recovery. Otherwise it will instigate a socioeconomic crisis ahead of the all-important political reshuffle in fall 2022. That would be the opposite of what Xi Jinping needs as he tries to consolidate power. Chinese households have stored their wealth, built up over decades of economic success, in the housing sector (Chart 6). Economic instability could translate to political instability. Chart 6Beijing Will Provide Bailouts And Stimulus … Or Face Political Instability Investors often ask how the government can ease policy if doing so will further inflate housing prices, which hurts the middle class and is the opposite of the common prosperity agenda. High housing prices are the biggest of the three “mountains” that are said to be crushing the common folks and weighing on Chinese birthrates and fertility (the other two are high education and medical costs). The answer is that while policymakers want to cap housing prices and encourage fertility, they must prevent a general collapse in prices and economic and financial crisis. There is no evidence that suppressing housing prices will increase fertility or birthrates – if anything, falling fertility is hard to reverse and goes hand in hand with falling prices. Rather, evidence from the US, Japan, South Korea, Thailand, and other countries shows that a bursting property bubble certainly does not increase fertility or birthrates (Charts 7A and 7B). Chart 7AEconomic Crash Not A Recipe For Higher Fertility Chart 7BEconomic Crash Not A Recipe For Higher Fertility Bringing it all together, investors should not play down negative news and financial instability emerging from China. There are no checks and balances on autocrats. Our China Investment Strategy has a high conviction view that policy stimulus is not forthcoming and regulatory curbs will not be eased. The implication is that China’s government could make major policy mistakes and trigger financial instability in the near term before changing its mind to try to preserve overall stability. At that point it could be too late. Will Countries Add More Stimulus? Yes. Chart 8Global Monetary Policy Challenges With China’s stability in question, investors face a range of crosswinds. Central banks are struggling with a surge in inflation driven by stimulus-fueled demand and supply bottlenecks. The global output gap is still large but rapid economic normalization will push inflation up further if kinks are not removed (Chart 8). A moderating factor in this regard is that budget deficits are contracting in 2022 and coming years – fiscal policy will shift from thrust to drag (Chart 9). However, the fiscal drag is probably overstated as governments are also likely to increase deficit spending on the margin. The US is certainly likely to do so. But before considering US fiscal policy we must address the immediate question: whether the US will default on national debt. Treasury Secretary Janet Yellen has designated October 18 as the “X-date” at which the Treasury will run out of extraordinary measures to make debt payments if Congress does not raise the statutory debt ceiling. There is presumably a few weeks of leeway after this date but markets will grow very jittery and credit rating agencies will start to downgrade the United States, as Standard & Poor’s did in 2011. Chart 9Global Fiscal Drag Rears Its Head Democrats have full control of Congress and can therefore suspend the debt ceiling through a party-line vote. They can do this through regular legislation, if Republicans avoid raising a filibuster, though that requires Democrats to make concessions in a back-room deal with Republicans. Or they can compromise the filibuster, though that requires convincing moderate Democrats who support the filibuster that they need to make an exception to preserve the faith and credit of the US. Or they can raise the debt ceiling via budget reconciliation, though this would run up against the time limit and so far Senate Leader Chuck Schumer claims to refuse this option. While the odds of a debt default are not zero, the Democrats have the power to avoid it and will also suffer the most in public opinion if it occurs. Therefore the debt limit will likely be suspended at the last minute in late October or early November. Investors should expect volatility but should view it as short-term noise and buy on dips – i.e. the opposite of any volatility that stems from Chinese financial turmoil. Congress is likely to pass Biden’s $550 billion bipartisan infrastructure bill (80% subjective odds). It is also likely to pass a partisan social welfare reconciliation bill over the coming months (65% subjective odds). The full impact on the deficit of both bills should range from $1.1-$1.6 trillion over ten years. This will not be enough to prevent the fiscal drag in 2022 but it will provide for a gradually expanding budget deficit over the course of the decade (Chart 10). Chart 10New Fiscal Stimulus Will Reduce Fiscal Drag On Margin The reconciliation package will be watered down and late in coming. Investors will likely buy the rumor and sell the news. If reconciliation fails, markets may cheer, as it will also include tax hikes and pose the risk of pushing up inflation and hastening Fed rate hikes. Elsewhere governments are also providing “soft budgets.” The German election results confirmed our forecast that the government will change to left-wing leadership that will be able to boost domestic investment but not raise taxes. This is due to the inclusion of at least one right-leaning party, most likely the Free Democrats. Fiscal deficits will go up. Germany has a national policy consensus on most matters of importance and thus can pass some legislation. But the new coalition will be ideologically split and barely have a majority in the Bundestag, so controversial or sweeping legislation will be unlikely. This outcome is positive for German markets and the euro. Looking at popular opinion toward western leaders and their ruling coalitions since the outbreak of COVID-19, the takeaway is that the Europeans have the strongest political capital (Chart 11). Governments are either supported by leadership changes (Italy, Germany) or likely to be supported in upcoming elections (France). The UK does not face an election until 2024, unless an early election is called. This seems doubtful to us given the government’s strong majority. Chart 11DM Shifts In Popular Opinion Since COVID-19 Chart 12EM Shifts In Popular Opinion Since COVID-19 After all, Canada called an early election and it became a much riskier affair than the government intended and did not increase the prime minister’s political capital. Spain is far more likely to see tumult and an early election. Japan’s election in November will not bring any surprises: as we have written, Kishidanomics will be Abenomics by a different name. The implication is that after November, most developed markets will be politically recapitalized and fiscal policy will continue to be accommodative across the board. In emerging markets, popular opinion has been much more damning for leaders, calling attention to our expectation that the aftershocks of the global pandemic will come in the form of social and political instability (Chart 12). Russia has a record of pursuing more aggressive foreign policy to distract from its domestic ills. The next conflict could already be emerging, with allegations that it is deliberately pushing up natural gas prices in Europe to try to force the new German government to certify and operate the NordStream II pipeline. The Americans are already brandishing new sanctions. Chart 13Stary Neutral Dollar For Now Brazil and Turkey both face extreme social instability in the lead-up to elections in 2022 and 2023. India has been the chief beneficiary of today’s climate but it also faces an increase in political and geopolitical risk due to looming state elections and its increasing alliance with the West against China. Putting it all together, the US is likely to stimulate further and pump up inflation expectations. Europe is politically stable but Russia disrupt it. Other emerging markets, including China, will struggle with economic, political, and social instability. This is an environment in which the US dollar will remain relatively firm and the renminbi will depreciate – with negative effects on EM currencies more broadly (Chart 13). Annual Views On Track Our three key views for 2021 are so far on track but face major tests in the fourth quarter: 1. China’s internal and external headwinds: If China overtightens policy and short-circuits the global economic recovery, then its domestic political risks will have exceeded even our own pessimistic expectations. We expect China to ease fiscal policy and do at least the minimum to secure the recovery. Investors should be neutral on risky assets until China provides clearer signals that it will not overtighten policy (Chart 14). 2. Iran is the crux of the US pivot to Asia: A crisis over Iran is imminent since Biden did not restore the 2015 nuclear deal promptly upon taking office. Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Brent crude oil prices will see upside risks relative both to BCA forecasts and the forward curve (Chart 15). Chart 14Wait For China To Relax Policy Chart 15Expect A Near-Term Crisis Over Iran The reason is that Iran is expected to reach nuclear “breakout” capability by November or December (i.e. obtain enough highly enriched uranium to make a nuclear device). The Biden administration is focused on diplomacy and so far hesitant to impose a credible threat of war to halt Iranian advances. Israel’s new government has belatedly admitted that it would be a good thing for the US and Iran to rejoin the 2015 nuclear deal – if not, it supports a global coalition to impose sanctions, and finally a military option as a last resort. Biden will struggle to put together a global coalition as effective as Obama did, given worse relations with China and Russia. The US and Israel are highly likely to continue using sabotage and cyberattacks to slow Iran’s nuclear and missile progress. Chart 16Pivot To Asia Runs Through Iran Chart 17Europe: A Post-Trump Winner? Depends On China Thus the Iranians are likely to reach breakout capability at which point a crisis could erupt. The market is not priced for the next Middle East crisis (Chart 16). Incidentally, any additional foreign policy humiliation on top of Afghanistan could undermine the Biden administration more broadly, in both domestic and foreign policy. 3. Europe benefits most from a post-pandemic, post-Trump world: Europe is a cyclical economy and is also relatively politically stable in a world of structurally rising policy uncertainty and geopolitical risk. We thought it stood to benefit most from the global recovery and the passing of the Trump administration. However, China’s policy tightening has undermined European assets and will continue to do so. Therefore this view is largely contingent on the first view (Chart 17). Investment Takeaways Strategically we maintain a diversified portfolio of trades based on critical geopolitical themes: long gold, short China/Taiwan, long developed markets, long aerospace/defense, long rare earths, and long value over growth stocks. Taiwanese equities have continued to outperform despite bubbling geopolitical tensions. We maintain our view that Taiwan is overpriced and vulnerable to long-term semiconductor diversification as well as US-China conflict. Our rare earths basket, which focuses on miners outside China, has been volatile and stands to suffer if China’s growth decelerates. But global industrial, energy, and defense policy will continue to support rare earths and metals prices. Russian tensions with the West have been manageable over the course of the year and emerging European stocks have outperformed developed European peers, contrary to our recommendation. However, fundamental conflicts remain unresolved and the dispute over the recently completed Nord Stream II pipeline to Germany could still deal negative surprises. We will reassess this recommendation in a future report. We are booking gains on the following trades: long Mexico (8%), long aerospace and defense in absolute terms (4%), long EU industrials relative to global (4%), and long Italian BTPs relative to bunds (0.2%).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Appendix: Geopolitical Calendar

HighlightsThe power shortage in China due to depleted coal inventories and low hydro availability will push copper and aluminum inventories lower, as refineries there – which account for roughly one-half of global capacity – are shut to conserve power (Chart of the Week).Given the critical role base metals will play in the decarbonization of the global economy, alternative capacity will have to be incentivized ex-China by higher prices to reduce refining-concentration risk in the future.Unexpectedly low renewable-energy output in the EU and UK following last year's cold winter will keep competition with China for LNG cargoes elevated this winter.  It also highlights the unintended consequences of phasing down fossil-fuel generation without sufficient back-up.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere.  Normal-to-warmer temps cannot be entirely dismissed, however.Increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers.We remain long 1Q22 natgas exposure via call spreads; long commodity index exposure (S&P GSCI and COMT ETF) to benefit from increasing backwardation as inventories of industrial commodities fall; and long the PICK ETF to benefit from expected tightening of base metals markets.FeatureNatgas prices are surging in the wake of China's and Europe's scramble to cover power shortages arising from depleted coal inventories and low hydroelectric generation in the former, and unexpectedly low output from renewables in the latter (Chart 2).1Given all the excitement of record-high gas prices in the EU and surging oil prices earlier this week, it is easy to lose sight of the longer-term implications of these developments for the global decarbonization push. Chart of the WeekBase Metals Refining Concentrated In China  Chart 2Surge In Gas Prices Continues Global copper inventories have been tightening (Chart 3) along with aluminum balances (Chart 4).2 Power shortages in China- which accounts for ~40% of global refined copper output and more than 50% of refined aluminum - are forcing shutdowns in production by authorities seeking to conserve energy going into winter. In addition, the upcoming Winter Olympics in February likely will keep restrictions on steel mills, base-metals refiners, and smelters in place, so as to keep pollution levels down and skies blue. Chart 3Supply-Demand Balance Tightening In Copper  Chart 4Along With Aluminum Balances... This will keep prices well supported and force manufacturers to draw on inventories, which will keep forward curves for copper (Chart 5) and aluminum (Chart 6) backwardated. Higher costs for manufactured goods can be expected as well, which will exacerbate the cost-push inflation coming through from clogged global supply chains. This slowdown in global supply chains is largely the result of global aggregate demand improving at a faster rate than supply.3 Chart 5Copper Prices And Backwardation  Chart 6...Will Increase Along With Aluminum The pressures on base metals markets highlight the supply-concentration risks associated with the large share of global refining capacity located in China. This makes refined base metals supplies and inventories globally subject to whatever dislocations are impacting China at any point in time. As the world embarks on an unprecedented decarbonization effort, this concentration of metals refining capacity becomes increasingly important, given the centrality of base metals in the build-out of renewable-energy and electric-vehicles (EVs) globally (Chart 7).In addition, increasing tension between Western states and China supports arguments to diversify supplies of refined metals in the future (e.g., the US, UK and Australia deal to supply US nuclear-powered submarine technology to Australia, and the tense Sino-Australian trade relationship that led to lower Chinese coal inventories).4 Chart 7The Need For Refined Metals Grows EU's Renewables Bet SoursUnlike China, which gets ~ 11% of its electricity from renewables and ~ 63% of its power from coal-fired generation (Chart 8), the EU gets ~ 26% of its power from renewables and ~ 13% from coal (Chart 9). In fact, the EU's made a huge bet on renewables, particularly wind power, which accounts for ~55% of its renewables supply. Chart 8China's Dependence On Coal …  Chart 9… Greatly Exceeds The EU's Unexpectedly low renewable-energy output in the EU and UK this summer – particularly wind power – forced both to scramble for natgas and coal supplies to cover power needs.5 As can be seen in Chart 9, the EU has been winding down its fossil-fuel-fired electric generation in favor of renewables. When the wind stopped blowing this year the EU was forced into an intense competition with China for LNG cargoes in order to provide power and rebuild storage for the coming winter (Chart 10). Chart 10The Scramble For Natgas Continues The current heated – no pun intended – competition for natgas going into the coming winter is the result of two policy errors, which will be corrected by Spring of next year. On China's side, coal inventories were allowed to run down due to diplomacy, which left inventories short going into winter. In the EU, wind power availability fell far short of expectations, another result of a policy miscalculation: Nameplate wind capacity is meaningless if the wind stops blowing. Likewise for sun on a cloudy day.Natgas Price Run-Up Is TransitoryThe run-up in natgas prices occasioned by China's and the EU's scramble for supplies is transitory. Still, uncertainty as to the ultimate path global gas prices will take is at its maximum level at present.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere. Even so, this is a probabilistic assessment: Normal-to-warmer temps cannot be dismissed, given this probability. A normal to warmer winter would leave US inventories and the availability to increase LNG exports higher, which would alleviate much of the pricing pressure holding Asian and European gas prices at eye-watering levels presently.Going into 1Q22, we expect increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers as hospitalization and death rates continue to fall (Chart 11).6 At that point, we would expect economic activity to pick up significantly, which would be bullish for natgas. We also expect US and Russian natgas production to pick up, with higher prices supporting higher rig counts in the US in particular. Chart 11Expect Continued COVID-19 Progress Investment ImplicationsAs the world embarks on an unprecedented decarbonization effort, it is important to follow the supply dynamics of base metals, which will provide the materials needed to build out renewable generation and EVs.The current price pressure in natural gas markets resulting from policy miscalculations cannot be ignored. Still, this pressure is more likely to be addressed quickly and effectively than the structural constraints in base metals markets.On the base metals side, producers remain leery of committing to large capex projects at the scale implied by policy projections for the renewables buildout.7In addition, current market conditions highlight concentration risks in these markets – particularly on the refining side in base metals, where much of global capacity resides in China. On the production and refining side of EV materials, battery technology remains massively concentrated to a few countries (e.g., cobalt mining and refining in the Democratic Republic of Congo and China, respectively).This reinforces our view that oil and gas production and consumption likely will not decay sharply unless and until these capex issues and concentration risks are addressed. For this reason, we remain bullish oil and gas. Robert P. Ryan Chief Commodity & Energy Strategistrryan@bcaresearch.comAshwin ShyamResearch AssociateCommodity & Energy Strategyashwin.shyam@bcaresearch.com Commodities Round-UpEnergy: BullishDelegates at OPEC 2.0's Ministerial Meeting on Monday likely will agree to increase the amount of oil being returned to markets by an additional 100-200k b/d. This would take the monthly production rate of production being restored from 400k b/d to 500-600k b/d. Depending on how quickly mRNA vaccine production in large EM markets is rolled out, this incremental increase could remain in place into 2Q22. This would assuage market concerns prices could get to the point that demand is destroyed just as economic re-opening is beginning in EM economies. Our view remains that the producer coalition led by Saudi Arabia and Russia will continue to balance the need for higher revenues of member states with the fragile recovery in EM economies. We continue to expect prices in 2022 to average $75/bbl and $80/bbl in 2023 (Chart 12). This allows OPEC 2.0 states to rebuild their balance sheets and fund their efforts to diversify their economies without triggering demand destruction.Base Metals: BullishA power crunch and decarbonization policies in China are supporting aluminum prices at around 13-year highs, after reaching a multi-year peak earlier this month (Chart 13). The energy-intensive electrolytic process of converting alumina to metal makes aluminum production highly sensitive to fluctuations in power prices. High power prices and electricity shortages are impacting aluminum companies all over China, one of which is Yunnan Aluminium. According to the Financial Times, the company accounts for 10% of total aluminum supply in the world’s largest producer.Precious Metals: BullishGold prices dipped following a hawkish FOMC meeting last week. More Fed officials see a rate hike in 2022, compared to the previous set of projections released in June. Fed Chair Jay Powell also hinted at a taper in the asset purchase program on the back of a rebounding US economy, provided a resurgence in COVID-19 does not interrupt this progress. A confirmation of what markets were expecting – i.e., paring asset purchases by year-end – and possible rate hikes next year have buoyed the US dollar and Treasury yields. The USD competes directly with gold for safe-haven investment demand. Higher interest rates will increase the opportunity cost of holding the yellow metal. As a result, gold prices will be subdued when the USD is strengthening. We remain bearish the USD, and, therefore, bullish gold. Chart 12Oil Forecasts Hold Steady  Chart 12Aluminum Prices Recovering   Footnotes1     Please see China's Yunnan imposes output curbs on aluminium, steel, cement makers published by reuters.com on September 13, 2021.2     NB: Global aluminum inventory data are unreliable and we do not publish them.3    Please see, e.g., Supply Chains, Global Growth, and Inflation, published by gspublishing.com on September 20, 2021.4    Please see US-China: War Preparation Pushes Commodity Demand, a Special Report we published on August 26, 2021, for further discussion.5    We discuss this in last week's report entitled Natgas Markets Continue To Tighten, which is available at ces.bcaresearch.com.6    Please see Upside Price Risk Rises For Crude, which updated our oil-price balances and forecasts. We highlight the recent agreements to mass produce the highly effective mRNA COVID-19 vaccines globally as bullish for oil prices. It also will be bullish for natgas and other commodities.7     Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021, for additional discussion. Investment Views and ThemesStrategic RecommendationsTactical TradesCommodity Prices and Plays Reference TableTrades Closed in 2021Summary of Closed Trades

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound   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 Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations