Currencies

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversations, which we held remotely for a second year in a row due to the COVID-19 pandemic.   Mr. X: It is typically the case that I look forward to our end of year conversations, as they always help clarify the investment landscape for my daughter and I. This year, the feeling of excitement has unusually given way to a sense of foreboding. As far as the pandemic is concerned, clearly this year was a better one than last year, and I am encouraged by the progress that has been made around the world at protecting people from COVID-19 – although I do have some questions about the recent discovery of the Omicron variant. Risky assets have generally performed well year-to-date, and our portfolio has benefitted from that. But the longer-term investment outlook has certainly deteriorated: equity market multiples remain extremely elevated, government debt loads are still extraordinarily high, and now we have finally seen a surge in inflation – which, as you know, I have been concerned about for several years. I feel strongly that investors are unprepared for the eventual policy consequences of what has happened this year. Financial markets have been underpinned by easy money for too long, and if interest rates have to rise on a structural basis to control inflation, the financial market consequences will be severe – let alone the potential political and social consequences! I have steeled myself for a depressing conversation. Ms. X: As you may have sensed during our discussions over the past few years, I tend to have a more optimistic outlook than my father does. At a minimum, I believe that there are always investment opportunities that one can pursue, regardless of whether the macro regime is bullish or bearish for economic activity and risky asset prices. But I do have to say that the extent of the rise in consumer prices this year has unnerved me and made me marginally more inclined to agree with my father’s pessimistic long-term outlook. It is very unsettling to see headline inflation in the US at its highest level in three decades, and I very much hope that you will be able to provide some perspective about whether elevated inflation is here to stay. But before we get into our discussion of the outlook, perhaps we can briefly review your predictions from last year? BCA: Certainly. A year ago, our key conclusions were the following: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS. Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. Most of our investment recommendations panned out quite well this year (Table 1). Global stocks significantly outperformed long-maturity government bonds, advanced economies grew meaningfully above trend, monetary policy remained extremely easy, long-maturity bond yields rose moderately, and our call to favor cyclical sectors was a profitable one. Our bullish oil call worked out especially well, with Brent prices having risen roughly 60% from the beginning of the calendar year until the discovery of the Omicron variant. It remains 43% above its late-2020 level. Table 12021 Asset Market Returns OUTLOOK 2022: Peak Inflation – Or Just Getting Started? OUTLOOK 2022: Peak Inflation – Or Just Getting Started? A few calls did not perform in line with our expectations, however. We favored value versus growth stocks this year, and this call did work out in the first half of 2021. However, growth rallied in the back half of the year, in response to a renewed decline in long-maturity bond yields that was catalyzed by the emergence of the Delta variant. We would note that financials did outperform broadly-defined technology stocks this year (the two main representative sectors of the value and growth styles, respectively), underscoring that other factors impacted the overall value versus growth call. DM ex-US stocks underperformed this year, contrary to our expectations. When considering the euro area as a proxy for DM ex-US and when examining combined sector effects (both sector weight and performance) in local currency terms, almost all of the underperformance this year occurred due to the euro area’s comparatively low weight in the information technology and communication services sectors, underscoring that there has been a value vs. growth dimension to European equity underperformance. But when measured in common currency terms, the underperformance of DM ex-US stocks has mostly occurred due to the rise in the US dollar. The dollar was flat to down for the first half of the year, in line with our prediction, but rallied in the back half – especially over the past month, as new COVID cases surged in several European countries. Within the commodity space, our oil call worked out extremely well but gold fared poorly. This underscores that gold is far more sensitive to real interest rate dynamics than it is to the US dollar trend, which likely has bearish long-term implications for the yellow metal. We can address that later when we discuss the commodity outlook. Finally, we argued last year that we were experiencing a secular inflection point in inflation, but we did not anticipate the magnitude of the rise in consumer prices this year. As we will discuss in a moment, that reflects major pandemic-induced supply-side effects affecting consumer prices, which we believe will wane next year on average. That does not, however, mean that demand-side factors are irrelevant, and we do believe that core inflation will come in higher than the Fed currently expects in 2022. Peak Inflation – Or Just Getting Started? Ms. X: You mentioned the pandemic in your comments about supply-side inflation, and I feel that it would be a good idea to get your thoughts about COVID-19 up front. As my father noted, there has been enormous progress made this year towards ending the pandemic, but it is not yet over – as evidenced both by Europe’s recent 5th wave, as well as this highly concerning Omicron variant. I understand that you are not medical professionals, but what is your base case view of what is likely to happen next year? BCA: When we discussed last year’s outlook, it was certainly our hope that we would have declared a decisive victory in the war against COVID-19 by this point. That has not occurred, due to three major factors. Chart 1Vaccination Rates Are Too Low To Stop COVID From Circulating Vaccination Rates Are Too Low To Stop COVID From Circulating Vaccination Rates Are Too Low To Stop COVID From Circulating The first was the emergence of the Delta variant of COVID-19 in the middle of the year. Delta’s transmission and serious illness rate is higher than the original SARS-COV-2 virus and its Alpha variant, which rendered the goal of true herd immunity unachievable. The Delta variant of SARS-COV-2 has accounted for all new confirmed cases of COVID-19 around the world (until very recently), meaning that the bar for ending the pandemic has risen this year. Vaccine hesitancy and a slow approval process for vaccinating children is the second factor that has prolonged the end of the COVID-19 pandemic. While vaccine penetration has generally been high in most countries, a combination of hesitancy and the inability to vaccinate children under the age of 12 has left 1/4th to 1/3rd of the population of advanced economies unprotected against COVID-19. That might have been enough to prevent rising transmission of the original SARS-COV-2 virus, but it has proven to be too low to durably stop the ongoing spread of the Delta variant once disease control measures are relaxed or eliminated (Chart 1). In fact, as you noted, Chart 1 highlights that a 5th wave of the pandemic is in the process of occurring, especially within Europe. The vaccination of children has already begun in the United States and a few other countries, and many countries will likely follow suit in the weeks and months ahead. However, vaccination rates are likely to be lower among children given the considerably lower risk of severe illness, and it is clear that vaccine hesitancy among adults is sticky. The extent of vaccine hesitancy is most visible in the United States, where it has taken on a political dimension. Chart 2 highlights that US state vaccination rates are strongly predicted by the 2020 US Presidential election results, with states that voted for Donald Trump having on average a 12% lower vaccination rate than those that voted for Joe Biden. Chart 2 The third factor that has prolonged the pandemic, which seems to be linked to the emergence of the Omicron variant, is the fact that poorer parts of the world have not been able to make as much progress in vaccinating their populations, at least in part due to vaccine nationalism. We do not pass judgement on the governments of richer economies for prioritizing their own citizens, and indeed it would be hypocritical for us to do so as most of us at BCA have personally benefitted from that. But the consequence of those decisions is that some parts of the world, especially in Africa, have been left as de-facto breeding grounds for new variants. While the Omicron variant only came to light in the days leading up to the publication of this report, it does appear based on the available data that the variant emerged in Africa. Given all of this, we would be considerably more cautious in our outlook for the global economy next year if the progression of the pandemic were only dependent on the vaccination rate, especially now given the emergence of Omicron. However, two other factors will strongly influence the evolution of the pandemic and its impact on economic activity over the coming 12 months. First, in the US, states with a comparatively low vaccination rates likely have higher acquired immunity levels from previous infections, given that these states have recorded higher confirmed cases on a per capita basis. Chart 3The Delta Strain On US Hospitals Has Fallen, And Will Fall Further With Anti-Viral Drugs The Delta Strain On US Hospitals Has Fallen, And Will Fall Further With Anti-Viral Drugs The Delta Strain On US Hospitals Has Fallen, And Will Fall Further With Anti-Viral Drugs Second, and much more important, is the fact that anti-viral drug treatments with the ability to significantly reduce hospitalization and death have been discovered and are already under production. Molnupiravir, developed/produced by Merck and Ridgeback Biotherapeutics, has been shown to reduce the risk of hospitalization by 30%, and Merck is projecting that 10 million courses of treatment will be available by the end of December 2021, with at least 20 million courses to be produced next year. 1.7 million courses of treatments are set to be delivered to the US upon FDA approval, which compares with approximately 2 million COVID-related hospitalizations in the US over the past year. Chart 3 highlights that US ICU bed occupancy has already lessened, and the imminent deployment of effective drugs should lower ICU utilization even further over the winter months. Paxlovid, Pfizer’s oral anti-viral treatment for COVID-19, has been shown to be even more effective at reducing hospitalization, and news reports suggest the US government will order enough Paxlovid to treat 10 million Americans. Pfizer expects to produce roughly 50 million courses of treatment in 2022, and recently agreed to allow 95 developing countries to produce Paxlovid locally, suggesting that the impact of COVID-19 on the global medical system will be greatly reduced next year. This seems likely to be true even given the emergence of Omicron, as Paxlovid works by stopping the virus from replicating, by blocking an enzyme that does not appear to have mutated since the onset of the pandemic. Paxlovid does not target the spike protein, unlike monoclonal antibody treatments. Ms. X: The development of anti-viral treatments was seen as a very positive announcement because it had the strong potential to reduce or eliminate the impact of vaccine hesitancy on the medical system. But this new variant appears to be vaccine-resistant; doesn’t that mean that we might need far more of these drugs than we originally thought? BCA: Indeed. The fact that Omicron appears to be even more contagious than Delta and at least partially vaccine-resistant is legitimately concerning, because it could mean that many more courses of treatment of Molnupiravir and Paxlovid will be needed than will be available in the coming weeks and months to prevent a sharp rise in hospitalizations and deaths. At the same time, public comments by South African doctor Angelique Coetzee, who chairs the South African Medical Association and treated several patients suspected of having been infected with the Omicron variant, suggest that it may produce milder symptoms – which would be associated with a lower hospitalization rate.1 If Omicron outcompetes the Delta variant of the virus, but produces less severe disease, that could ironically prove to be a positive development. The fact that Omicron could render monoclonal antibody treatments useless could further reduce vaccine hesitancy in advanced economies and encourage the vaccination of children. That would further reduce the total incidence of severe illnesses even if Omicron is partially vaccine-resistant, and thus would be positive from the perspective of reducing the burden on the health care system. Still, South Africa’s population is considerably younger than those of advanced economies, and we will not know for some time whether a reduction in severe illness, if that proves to be true, applies also to those who are older. If Omicron threatens a significant hospitalization or fatality rate among the elderly who have been fully vaccinated, Omicron-specific booster shots for that age cohort will likely be required – which could take 3-4 months to become available. If that proves to be the path forward, the widespread reintroduction of “non-pharmaceutical interventions” (NPIs) – the policymaker codeword for travel bans, school closures, and lockdowns – is certainly a possible outcome in the first quarter. Omicron will have at least some impact on global travel over the coming month, as countries around the world decide to err on the side of caution and impose travel restrictions while more information is gathered about this new variant. To conclude on this question, as you noted, we are not medical experts. And frankly even if we were, we would not be able to project exactly how the pandemic will unfold next year. Thus, there is more uncertainty concerning our 2022 outlook than would normally be the case. Prior to the emergence of Omicron, our base case view was that the pandemic would meaningfully recede in importance next year, which would lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. For the reasons that we have laid out, we have not yet seen enough information to change that view for 2022 as a whole, although the opposite will likely be true for the next few weeks at a minimum. We may have to have you both back for another discussion in the first half of next year to revisit our outlook, but for now it is not our expectation that we are back to square one on the pandemic front. Chart 4A 30-Year High In US Inflation A 30-Year High In US Inflation A 30-Year High In US Inflation Mr. X: Thank you for your insights. Although this is clearly a concerning development, I suppose that there is no use panicking yet, as we do not have the information that we need to make an informed judgement. Perhaps we can turn to the question of inflation, given that seems likely to be an important economic and policy factor next year regardless of whether Omicron extends the duration of the pandemic. As both my daughter and I highlighted, this year’s rise in consumer prices was extreme, at least by the standard of the past three decades. As you know, I have my own views about why this has occurred, and I suspect that you do not fully agree with me. But for the sake of our discussion, please outline your views about what has occurred this year, and what that implies for policy and financial markets. BCA: As you noted, in both the US and euro area economies, headline consumer price inflation rose this year to their highest levels since the early-1990s (Chart 4). The rise in core inflation has been less extreme in the euro area, but it is also back to early-1990s levels in the US (panel 2). It is understandable that investors are worried about inflation remaining very elevated, and we agree that US inflation will likely be both above the Fed’s target as well as its forecast next year. However, our base case view is that investors are currently overestimating the magnitude of inflation over the coming 12 months, and that actual inflation will come in lower next year than what short-maturity inflation expectations are currently suggesting. As such, we do not expect that inflation next year will lead to a major shift in the monetary policy outlook, and we would continue to recommend that global investors stay overweight stocks versus bonds in 2022. Mr. X: I am surprised that you have a sanguine inflation outlook given how sharply consumer prices have risen this year. It sounds like you are blindly accepting the “transitory” narrative that central banks themselves are now questioning! This year’s surge in consumer prices has several causes, and a review of these factors is necessary to predict how future prices are likely to evolve. Fundamentally, any change in price can be traced to changes in supply and demand, and both of those effects worked in the direction of higher consumer prices this year. Chart 5 outlines the clear evidence of demand-side effects. The US fiscal response to the pandemic was more forceful than in the euro area, and US core consumer prices have correspondingly risen much more than in Europe. The chart highlights that US durable goods prices have been responsible for more of the surge in prices this year than has been the case for services, reflecting strong goods demand from US consumers. Chart 6 highlights that US real goods spending is 9.8% above its pre-pandemic trend, whereas it is 4.5% below for services. Extremely strong goods demand partially reflects the impact of fiscal and monetary stimulus, but also a shift in spending from services to goods owing to the nature of the pandemic and the type of activity that it has restricted. We expect that another shift in spending mix will occur next year in the opposite direction, barring a major extension of the pandemic from Omicron. Chart 5A Breakdown Of US Inflation Provides Clear Evidence For Demand-Pull Effects A Breakdown Of US Inflation Provides Clear Evidence For Demand-Pull Effects A Breakdown Of US Inflation Provides Clear Evidence For Demand-Pull Effects Chart 6US Goods Demand Is Well Above Trend US Goods Demand Is Well Above Trend US Goods Demand Is Well Above Trend You referenced the “transitory” debate in your question, and the answer to whether above-target inflation is likely to be transitory is both yes and no. Many of the supply-side effects that are driving prices are transitory, in the sense that they will not last beyond the pandemic. That view should not be controversial. But, some of the demand-side effects lifting prices are not. Chart 7A Shortage Of Service-Sector Workers Has Boosted Wages And Services Prices A Shortage Of Service-Sector Workers Has Boosted Wages And Services Prices A Shortage Of Service-Sector Workers Has Boosted Wages And Services Prices In the US, supply effects are seen by observing services prices. Services prices in the US have risen despite a collapse in demand, pointing to supply-side effects as the dominant driver of higher prices. A significant decline in labor force participation has caused a shortage of workers, which is driving up wages for the first quartile of wage earners (the lowest paid) who often work in service-providing industries (Chart 7). Faced with higher labor costs alongside low operating margins and the expectation that demand will continue to recover, service providers have raised prices to stay afloat. The specific causes of the ongoing labor market shortage in the US are multifaceted, but most relate directly to the pandemic: There has been a surge in the number of retirees, mainly driven by a sharp slowdown in the number of older Americans (who are more vulnerable to COVID-19) shifting from “retired” to “in the labor force”. Workers in some sectors of the economy that experienced a surge in demand during the pandemic (technology, health care, food products, transportation, and manufacturing) have experienced burnout and have quit their jobs. Some service-sector workers have complained of difficult working conditions during the pandemic (the need to wear masks, the policing of masks and vaccination passports, overwork due to short-staffed conditions, negative interactions with customers, etc.) and have instead chosen not to work until these conditions improve. Some parents have been unable or unwilling to reenter the labor force due to increased childcare requirements resulting from daycare/school/classroom closures. Chart 8Fewer Immigrants = Higher Wages Fewer Immigrants = Higher Wages Fewer Immigrants = Higher Wages Chart 8 highlights that legal immigration to the US collapsed during the pandemic following a restriction in worker visas last year, which has also likely exacerbated worker shortages in some industries. Illegal immigration has surged over the past year, but illegal workers do not necessarily immediately enter the labor market and are often employed in a narrow set of industries. Mr. X: But if these supply-side effects that you are pointing to are mostly on the services side, does that not imply that goods inflation will remain very elevated next year due to excessive demand? BCA: No. As we mentioned, some of this goods spending is being funded by income that would normally go towards services spending. We doubt that a services spending deficit will be sustained if the pandemic recedes next year, meaning that some spending will naturally be diverted away from goods. Chart 9Supply-Side Effects Have Significantly Boosted Global Shipping Costs Supply-Side Effects Have Significantly Boosted Global Shipping Costs Supply-Side Effects Have Significantly Boosted Global Shipping Costs In addition, other supply-side factors are also impacting consumer prices for both goods and services, and on both sides of the Atlantic: Global shipping costs have surged, particularly for cargo containers traveling from China / East Asia to the west coast of the US. US demand for goods has certainly boosted shipping prices, but Chart 9 highlights that supply-side effects have also been present. The large rise in China/US shipping costs since late-June appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Semiconductor shortages have limited automotive production, thereby significantly boosting US vehicle prices. These shortages have occurred, in part, due to a global surge in semiconductor demand stemming from work-from-home policies, but also demand/supply coordination failures last year (auto producers initially cut chip orders on the expectation of collapsing car sales) and COVID-driven plant shutdowns in some Asian countries such as Malaysia. Energy prices have risen this year, partially due to supply-side / policy decisions. In the case of oil & gasoline prices, OPEC’s production decisions clearly reflect a desire to maintain oil prices at roughly $80/bbl, 30% above the level that prevailed prior to the pandemic. US shale producers have focused on repairing their balance sheets over the past year, and have not been able to take advantage of higher prices to boost output. Chart 10 highlights that US tight oil production remains roughly 10% below its pre-pandemic peak. In Europe, the impact of higher energy prices has occurred mainly though a spike in the price of natural gas, mostly due to weather, carbon pricing, Russian supply issues, and a surge in China’s natural gas demand. Chinese natural gas demand has surged in response to very strong manufacturing activity / export demand, but also previous decisions by Beijing to shift towards cleaner energy sources and the limitation of coal imports from certain countries (which has contributed to a collapse in Chinese coal inventories). So while it is clear that there is a strong underlying demand component that has boosted goods prices, supply-side factors have magnified the acceleration in consumer prices this year. Most of these supply-side factors (except for oil) have been directly linked to the pandemic, and thus are likely to wane in 2022 if the pandemic recedes (as we currently expect). In the case of oil, our view is that spot prices in 2022 are likely to average the price that prevailed prior to the Omicron-driven collapse in prices, meaning that the energy component that has been boosting headline price indexes this year will likely disappear next year even if recent travel bans are not long lasting and oil prices fully recover. Ms. X: Even if the pandemic does recede in importance and household spending shifts from goods to services next year, you acknowledged that goods spending is also being boosted by policy. This implies that goods spending will remain above trend next year, and that it will continue to boost consumer prices. Doesn’t that argue for elevated inflation? BCA: We agree that several factors point to above-trend goods spending next year, and this is the basis – in addition to lingering supply-side effects – for our view that US inflation will likely be both above the Fed’s target as well as its forecast for 2022 (2.2% headline and 2.3% core). However, Chart 11 shows a historically unprecedented “goods spending gap” relative to the overall output gap. It is unlikely that this has occurred only due to stimulative policy. Services spending collapsed during the pandemic, as Chart 6 highlights. So while goods spending will likely remain above its trend, supported by policy as well as a large stock of excess savings, it is likely to decline next year. Chart 10US Shale Production Has Not Returned To Its Pre-Pandemic Level US Shale Production Has Not Returned To Its Pre-Pandemic Level US Shale Production Has Not Returned To Its Pre-Pandemic Level Chart 11US Goods Spending Is Much Too Strong To Be Explained By Policy Alone US Goods Spending Is Much Too Strong To Be Explained By Policy Alone US Goods Spending Is Much Too Strong To Be Explained By Policy Alone   Lower goods demand in advanced economies will not only ease rising goods prices. It will also help ease Europe’s energy crisis, as it implies less competition for natural gas from China’s power companies which are struggling to supply the manufacturing sector. Chart 12Short-Term Inflation Expectations Have Exploded; Long-Term Expectations Are Contained Short-Term Inflation Expectations Have Exploded; Long-Term Expectations Are Contained Short-Term Inflation Expectations Have Exploded; Long-Term Expectations Are Contained Ms. X: One thing that has concerned me is how significantly inflation expectations have risen. Won’t persistent price increases become self-fulfilling if consumers and businesses come to expect inflation? BCA: This is a risk, and the dynamic that you are referring to is explicitly incorporated into modern-day interpretations of the Phillips Curve. However, if this were likely to occur, we should be able to observe a dangerous rise in both short- and long-dated inflation expectations on the part of investors, businesses, and households. Chart 12 highlights that long-term inflation expectations are not out of control. Short-term expectations for inflation have indeed exploded higher, but longer-term expectations remain under control. Inflationary pressure during the pandemic has normalized longer-term household expectations for inflation, which fell following the 2014/2015 collapse in oil prices. And long-dated market-based expectations for inflation have not even risen back to pre-2014 levels, underscoring that investors do not believe that current inflationary pressures are likely to persist. A breakout in long-dated inflation expectations next year would negatively alter our monetary policy and economic outlook, but it is clear that economic agents believe that current price pressure is directly linked to the pandemic. We agree, for the most part, and thus expect concerns about inflation to step down next year. Mr. X: Let’s turn to the question of extremely elevated government debt. We discussed this issue last year, and you noted that the explosion in public debt loads would carry significant future costs. Governments have been kicking the can down the road for a long time now, and I am interested in your perspective about the timing of the endgame. When do you think the day of reckoning will arrive? BCA: It is true that government debt-to-GDP ratios have risen substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. This has been truer in the US and UK than in the euro area, which has seen a comparatively smaller rise in government net debt as a % of GDP since the early 2000s (Chart 13). In the US, the government debt-to-GDP is now nearly as high as it was at the end of the Second World War. Chart 13 Chart 13 also highlights that the IMF is forecasting a reduction in government net debt as a share of GDP in the euro area over the coming 5 years, a modest rise in the UK, and larger rise in the US. Over a 30-year time horizon, the US government debt-to-GDP ratio is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years (Chart 14). Part of the CBO’s forecast of a catastrophic rise in government debt-to-GDP is due to projections of a persistent primary deficit that will grow over time. But it is also the case that the net interest component of the CBO’s projected deficit begins to rise significantly as a share of the total deficit at the start of the next decade. This rise in net interest payments occurs significantly because the CBO assumes that interest rates will eventually exceed the prevailing rate of economic growth due to crowding out effects (Chart 15). Chart 14The CBO's Long-Term Budget Outlook Is Dire... The CBO's Long-Term Budget Outlook Is Dire... The CBO's Long-Term Budget Outlook Is Dire... Chart 15...Partially Because Of The CBO's Interest Rate Assumptions ...Partially Because Of The CBO's Interest Rate Assumptions ...Partially Because Of The CBO's Interest Rate Assumptions   We doubt that this will occur, at least not in the linear fashion the CBO is projecting. It is true that central banks only control the short-end of the yield curve (absent yield curve control policies), meaning that investors could force yields on long-maturity government bond yields to rise above the prevailing level of nominal growth. But in a world of scarce absolute returns, it is unlikely that investors will price long-maturity US government bonds with an elevated term premium until the US government’s debt service burden becomes extreme. Given that a significant portion of the US government’s debt is issued with a short maturity, that debt service burden is at least partially a function of the Fed’s decisions, not those of bond investors. Chart 16US Taxes Are Low, Contributing To Its Primary Deficit US Taxes Are Low, Contributing To Its Primary Deficit US Taxes Are Low, Contributing To Its Primary Deficit An increase in real short-term interest rates over the coming several years might, ironically, be the best thing for US government debt sustainability over the long term, even though it would cause the US government’s debt service burden to rise. Ultimately, debt sustainability requires a balanced primary budget, and the structural US primary balance is heavily impacted by elevated medical costs and the fact that US government revenue as a share of GDP is considerably lower than in other countries (Chart 16). Given the political costs involved, primary balance reform in the US is unlikely to occur without some form of budgetary pressure from rising interest costs, and the longer the US government’s debt service burden remains low the longer that this reform is delayed. You asked about the timing of the endgame, and a potential tipping point may be when US government spending on net interest as a share of GDP exceeds the prior high reached in the early-1990s, which could occur as soon as 5 years from now were the Fed to raise interest rates towards the pace of nominal GDP growth.2Without such an increase, the US government’s debt burden will likely remain serviceable for decades, even without primary balance reform. Mr. X: I am happy that you referenced the Fed in your answer, because I wanted to address the question of central bank independence. Will elevated government debt prevent the Fed from raising rates if needed to control inflation? With the Fed projecting a very low Federal funds rate in the future, it seems like today’s central bankers may be incapable of acting as Volker did, should they need to do so. BCA: It is true that the Fed is projecting a very low average long-term Fed funds rate, but this projection is not due to political pressure or concerns about the US government’s future debt service burden. It reflects the Fed’s belief that the neutral rate of interest has fallen, based on the economic experience of the past decade, as well as the belief that an asymmetry exists in the economic costs of errors associated with estimating the neutral rate. On the latter point, the Fed believes that the cost of overestimating the neutral rate is likely to be higher than the cost of underestimating it, given the inability to cut interest rates meaningfully below zero. During our discussion last year, we noted that rising populism will make it very difficult for fiscal authorities to take preemptive action to address the US’s primary deficit, and it is possible that public opposition to normalized interest rates could cause the Fed to maintain easier monetary policy than is otherwise warranted – especially if the public perceives a link between Fed tightening and painful fiscal reform. However, our base case view remains that the Fed would resist these pressures, and would act in a way that the central bank felt was the best course of action to pursue its mandate. We would underscore that the risk of an overshoot in inflation from too-easy monetary policy does not require the Fed’s independence to become compromised. The Fed could be wrong in its assessment of the neutral rate of interest, and also wrong in its assessment of the costs of that error. Leaving the latter issue aside for now, there are good arguments in favor of the view that the neutral rate of interest is higher than the Fed currently believes. We can discuss those arguments in detail when we turn to the bond market outlook, but this does imply that inflation may be even more above the Fed’s target over the medium term than we believe will be the case next year. Ms. X: I have one last question related to inflation before we move on to your economic outlook. In terms of the usage of technology, the pandemic caused major behavioral changes to occur very quickly. Is it possible that we are on the cusp of a productivity boom, similar to what occurred during the 1990s, that will act to restrain inflation over the coming few years? BCA: It is possible that the pandemic has catalyzed some changes that will end up boosting productivity, given that many consumers, workers, and businesses were forced to embrace innovation quickly over the past 18 months. Governments have also made historic investments in both hard and soft infrastructure, including high-speed internet and renewable energy. But, for now, there is little evidence to support the idea that a major, technologically-driven productivity boom is occurring. Chart 17 Chart 17 highlights that measured productivity has fallen outside of the US since the pandemic began, and the US surge is likely explained by three factors: labor market composition effects, the fact that US productivity normally rises during recessions, and the fact that US fiscal response was more forceful than elsewhere (boosting spending and output relative to the number of workers). The cyclical characteristics of US measured productivity were particularly evident in Q3, when output per hour of all employees fell by roughly 5% on an annualized basis. It is also the case that the pandemic has likely lowered potential output in some areas of the economy, particularly sectors related to office worker presence in central business districts. Even if employer plans for workers to return to the office prevail and office presence increases significantly in 2022, it is very likely that some work-from-home activity will permanently stick and that this will structurally increase the US unemployment rate.3 For now, our sense is that this increase will be modest, but the key point is that the rapid adoption of new technology and ways of working during the pandemic have not occurred without cost, and it is far from clear that this will be productivity-enhancing on a net basis. The ongoing, typical pace of technological development may help ease inflationary pressures over the longer-term, but investors should not yet conclude that the pandemic has accelerated this process. The Economic Outlook Chart 18On Average, We Expect Above-Trend Growth In The DM World Next Year On Average, We Expect Above-Trend Growth In The DM World Next Year On Average, We Expect Above-Trend Growth In The DM World Next Year Ms. X: Thank you. I am not entirely sure that I am convinced, but I take your point that the productivity issue needs to be examined on a net basis. Let’s turn now to the outlook for growth next year. Starting first with developed markets, what do you expect in terms of the pace of economic growth, and how does that expectation differ from consensus market expectations? BCA: While we are less concerned about short-term inflation than most investors, we generally agree with consensus expectations for growth next year. Chart 18 shows that both official and private forecasts for real GDP growth in the US and euro area are well above trend, and that the US and euro area output gaps are likely to turn positive next year. In Q4 2021 and Q1 2022, it is possible that the Omicron variant will negatively impact economic growth. But assuming that the pandemic does recede in importance for the year as a whole, the basis for expecting above-trend growth in advanced economies next year is straightforward: we expect that monetary policy will remain extremely accommodative in the US and euro area, and will likely remain so even if the Fed begins to raise interest rates. In addition, the collapse in spending that occurred last year, arrayed against stable-to-higher income, has caused households to accumulate a massive amount of savings that will support consumption. Chart 19Households In The US And Europe Have Accumulated Excess Savings Households In The US And Europe Have Accumulated Excess Savings Households In The US And Europe Have Accumulated Excess Savings Chart 19 highlights that this has occurred in both the US and the euro area. In the euro area, income was relatively stable, and spending has yet to fully recover – supporting the view that a catch-up in European consumption will boost euro area growth to above-trend levels. In the US, personal income rose during the pandemic, because the US government issued stimulus checks to Americans who did not lose their job. Some of these excess savings have been spent or used to pay down debt, but a sizeable portion remains to support spending. Chart 20 highlights that US household net worth has exploded higher over the past 7 quarters, by a magnitude that far exceeds any other instance since the Second World War. It is true that fiscal policy will subtract from growth in both the US and euro area next year, although it remains an open question how much drag will occur in the US. Chart 21 presents the Hutchins Center Fiscal Impact Measure from the Brookings Institution, which suggests that US fiscal drag will be significant in 2022. This measure does not include the recent infrastructure bill, or the Build Back Better plan. However, Chart 22 presents the IMF’s projections for the US and euro area cyclically-adjusted budget balance, which suggest meaningfully less drag next year for the US. Chart 20US Household Net Worth Has Surged US Household Net Worth Has Surged US Household Net Worth Has Surged Chart 21 Chart 22 In the case of the euro area, Chart 22 highlights that the IMF is forecasting considerable fiscal drag next year, which seemingly contradicts optimistic expectations for euro area growth. There are two reasons to believe that euro area growth will be meaningfully above-trend in 2022, despite fiscal retrenchment. First, the IMF’s projected reduction in the euro area’s cyclically-adjusted primary deficit reflects the expiry of employment support programs such as the Kurzarbeit scheme in Germany, a social insurance program that incentivizes employers to reduce employee hours rather than laying off workers. The expiry of these types of programs is politically tied to a continued recovery in domestic consumption and further gains in service-sector employment, meaning that some of the fiscal drag projected in Chart 22 is necessarily linked to a growth impulse from the private sector. Certainly, these programs will be renewed or extended if the Omicron variant significantly weakens near-term economic growth in the euro area. Second, while the positive contribution to euro area growth from goods exports will likely wane over the coming year as spending in advanced economies shifts from goods to services, European services exports will eventually improve. Chart 23 highlights that the recovery in foreign tourist visits to the euro area is in its very early innings, and a normalization of tourist travel will eventually act as a significant contributor to income and employment growth in the region. According to the World Travel & Tourism Council, Europe was the third most impacted region globally from the decline in travel, after the Caribbean and Asia Pacific.4 It is clear that tourist travel will not pick up as long as Omicron-related travel bans are in effect, but Europe’s peak tourist season typically runs from June to August, which is beyond the range of time supposedly needed by vaccine manufacturers to produce Omicron-specific booster shots (should they be required). Chart 23European Tourism Will Eventually Recover, Adding To A Domestic Consumer Spending Tailwind European Tourism Will Eventually Recover, Adding To A Domestic Consumer Spending Tailwind European Tourism Will Eventually Recover, Adding To A Domestic Consumer Spending Tailwind Mr. X: I would like to challenge you on your growth view. First, the economy was already slowing, and now there is a risk that the Omicron variant might slow at least some economic activity even further in the near term. You have stated that there will be some degree of fiscal drag next year, and that savings might be deployed to support spending – but might not. Should I not be concerned that growth might fall back to trend or even below it? BCA: The pandemic was economically unprecedented, and investors should thus be careful about what growth rates are used to characterize the pace of ongoing economic activity. For example, Chart 24 highlights that euro area real GDP growth is slowing on a year-over-year basis, but it accelerated fractionally on a sequential basis in Q3 and grew substantially above-trend. It should not be surprising that advanced economies are no longer reporting double-digit growth rates given the ongoing recovery from extremely depressed rates of economic activity last year. The question is whether growth will slow dramatically further, and whether at or below trend growth is likely on average next year. Prior to the discovery of the Omicron variant, investors had little reason to be concerned about significantly below trend growth in 2022. Forward-looking economic indicators were not pointing to this outcome; Chart 25 shows our global Nowcast indicator, a high-frequency measure of economic activity that is designed to predict global industrial production, alongside our global leading economic indicator. The chart shows that both the Nowcast and global leading economic indicator (LEI) are indeed declining, but that this decline is occurring from an extremely elevated level. It is therefore correct to say that the global economy is at an inflection point in terms of the pace of growth, but Chart 25 still points to above-trend growth – and certainly not to a major cyclical downturn. Chart 24Growth In DM Economies Is Slowing, But Remains Above-Trend Growth In DM Economies Is Slowing, But Remains Above-Trend Growth In DM Economies Is Slowing, But Remains Above-Trend Chart 25Leading Indicators Continue To Point To Above-Trend Growth Leading Indicators Continue To Point To Above-Trend Growth Leading Indicators Continue To Point To Above-Trend Growth   The US economy did experience a very significant sequential slowdown in Q3, with activity having increased at only a trend rate. Chart 26 makes it clear that this occurred due to the impact of the semiconductor shortage on automotive production and the impact that the Delta wave of COVID-19 had on services spending. Real-time estimates for US growth in the fourth quarter are (for now) quite strong, and growth estimates for next year already likely incorporate the expectation of supply-side limitations. In fact, those expectations could surprise to the upside next year if these limitations ease more quickly than many investors currently expect, and if the Omicron variant turns out to be economically insignificant. If, however, the new variant does end up causing the return of lockdowns and other large-scale “NPIs” – especially in emerging market countries – the risk of further bottlenecks or an extension of existing supply-side problems will certainly rise. Chart 26 Chart 27 Ms. X: Could you provide us some scenarios that combine your growth and inflation views, as well as the odds that you would assign to them? BCA: Certainly. Chart 27 presents our odds of three scenarios for global growth and inflation next year. We assign a 60% chance to above-trend growth and above-target inflation, a 30% chance to a “stagflation-lite” scenario of growth at or below potential and inflation well above target, a 10% chance of a recession. We describe the second scenario as “stagflation-lite” because true stagflation, as experienced in the late-1970s, involved a very elevated unemployment rate. Using the US Misery Index as real-time stagflation indicator for advanced economies (Chart 28), investors should note that true stagflation is not likely unless the unemployment rate rises. Despite the ongoing impact of component and labor shortages, there is no evidence yet of a contraction in goods-producing or service-producing jobs. For now, the impact of outright component shortages appears to be limited to the auto sector. Chart 28It's Not True Stagflation Unless The Unemployment Rate Rises It's Not True Stagflation Unless The Unemployment Rate Rises It's Not True Stagflation Unless The Unemployment Rate Rises Even if goods-producing employment slows anew over the coming few months due to supply constraints, the unemployment rate is still likely to fall if services spending normalizes. This underscores the importance of services spending in advanced economies as a core driver of global economic activity over the coming year, given the ongoing weakness in several segments on China’s economy. Mr. X: My daughter and I have been closely watching China’s economy this year, and we have been getting increasingly concerned by the extent of the slowdown in activity there. Do you anticipate a pickup in Chinese growth in 2022? BCA: Yes, but a reacceleration in Chinese economic activity is more likely in the back half of next year than over the coming 6 months. There are three reasons for this. First, economic output in China will continue to be restrained over the coming months by the country’s ongoing energy crisis, which caused a sharp slowdown in electricity production in August (Chart 29). Production rebounded somewhat in September and October, but remained fairly weak. China’s energy crisis has occurred due to a combination of very strong electricity demand from the country’s manufacturing sector, as well as a significant reduction in coal emphasis, including coal imports from key producers that otherwise would have helped close the supply-demand gap (Chart 30). China’s coal stocks remain extremely low, underscoring that Chinese policymakers would not be capable of pushing through traditionally energy-intensive stimulus even if they were inclined to do so. Chart 29China's Energy Crisis Will Linger China's Energy Crisis Will Linger China's Energy Crisis Will Linger Second, strong external demand is supporting Chinese manufacturing employment (Chart 31), so Chinese policymakers feel less of a sense of urgency to boost economic growth despite a significant slowdown in China’s credit impulse and the ongoing slowdown in real-estate activity. Social stability will always remain the paramount objective of Chinese policymakers, and we fully expect a policy response if economic growth slows to the point that it impacts employment. Chart 30China's Energy Crisis: Strong Power Demand, Constrained Coal Supply China's Energy Crisis: Strong Power Demand, Constrained Coal Supply China's Energy Crisis: Strong Power Demand, Constrained Coal Supply Chart 31Strong External Demand Is Supporting Chinese Employment Strong External Demand Is Supporting Chinese Employment Strong External Demand Is Supporting Chinese Employment But because of the extreme rise in private-sector debt that has accumulated in China over the past decade, Chinese policymakers now perceive a tradeoff between economic growth and additional leveraging. This implies that the timing and magnitude of reflationary efforts from China’s policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth, in line with what occurred in 2018 and 2019. In fact, while many investors regard China’s policy response during that time as having been too timid, within China many commentators have lauded it as an example of finely balanced decision-making. Third, China’s zero-tolerance COVID policy will likely remain in effect at least until the Beijing Olympics in February, and potentially until the 20th National Party Congress in October. The potential risk from the Omicron variant will only reinforce the resolve of Chinese policymakers on this issue, which implies that Chinese consumption and services activity could follow a stop-and-go pattern over the coming 6 months. Chinese policymakers are likely aware that a zero-tolerance policy towards COVID is ultimately unsustainable, but we expect policymakers to react aggressively towards outbreaks next year in advance of these two major events. Ms. X: It sounds like Chinese policymakers do not want to stimulate at all. Why is a reacceleration in activity even likely? BCA: We expect further easing from Chinese policymakers next year because the strong demand for Chinese goods that is currently supporting employment is likely to slowly wane over the coming several months. Chinese export volume has been very closely tied to US real goods consumption over the past year (Chart 32), which, as we noted earlier, is 9.8% above the level implied by its pre-pandemic trend. A likely decline in US goods spending from current levels, even if it remains above trend, suggests that Chinese manufacturing employment will not be as strong on average next year as is currently the case. Chart 33 highlights the extent of the weakness in China’s credit impulse and its real estate sector, underscoring that China is currently a “one-legged” economy that is supported by manufacturing. Chart 32China's Exports And US Goods Spending Are Closely Linked China's Exports And US Goods Spending Are Closely Linked China's Exports And US Goods Spending Are Closely Linked Chart 33China's Economy Is Now Entirely Supported By External Demand China's Economy Is Now Entirely Supported By External Demand China's Economy Is Now Entirely Supported By External Demand     In addition, for political reasons, policymakers in China are very likely to want stable-to-improving economic conditions in the lead up to the National Party Congress in October. Given the lags between the implementation of stimulus and its effect on the economy, this points to further easing and/or outright stimulus in Q1 or Q2, and a reacceleration in economic activity in the latter half of the year. Chart 34Inflation Expectations, Not Real Rates, Have Been Driving The Bond Market Inflation Expectations, Not Real Rates, Have Been Driving The Bond Market Inflation Expectations, Not Real Rates, Have Been Driving The Bond Market Ms. X: Let’s turn now to monetary policy. You mentioned that monetary policy will remain very easy next year, but investors have moved to price between one and two interest rate hikes from the Federal Reserve in 2022. Do you agree with the market’s assessment? BCA: Our base case view is that investors are now overly hawkish and that an initial rate hike will most likely occur only in September or December 2022 – despite a seemingly hawkish pivot from the Fed. It is important to note that investors have moved up their expectations for rate hikes next year entirely in response to elevated inflation. Chart 34 highlights that the sharp increase in the US 2-year Treasury yield over the past few months has occurred alongside a decline in the real 2-year yield, underscoring that investors believe that inflation will force the Fed to raise interest rates earlier than it currently expects. We expect the pressure on prices to wane next year rather than intensify, meaning that rate-hike bets have likely been driven by the wrong factor. A dangerous rise in long-dated inflation expectations would change our view and validate market pricing. But, as we noted above, this has not yet occurred despite very elevated inflation this year and expectations of elevated inflation next year. This underscores that economic agents view the current pace of inflation as strongly linked to the pandemic, and thus see it as a temporary phenomenon. Table 2The Fed’s Liftoff Criteria OUTLOOK 2022: Peak Inflation – Or Just Getting Started? OUTLOOK 2022: Peak Inflation – Or Just Getting Started? Table 2 presents the three factors that will determine when the Fed decides to lift rates, based on the Fed’s official forward guidance. The two inflation-related criteria are currently checked, but the remaining labor market criterion is not checked. The Fed has officially pledged not to lift rates until “maximum employment” is reached, although that pledge may change in December. Still, we expect that progress towards “maximum employment” will influence the timing of the first rate hike unless there are no signs of easing inflation over the next several months. Our sense is that an unemployment rate close to 3.8% and a working-age participation rate close to its pre-pandemic level will be required to check the third box shown in Table 2. Chart 35The Working-Age Participation Rate Still Has Further To Rise The Working-Age Participation Rate Still Has Further To Rise The Working-Age Participation Rate Still Has Further To Rise Importantly, it is not clear that these factors will be in place before September next year. Chart 35 highlights that while the working-age participation rate has moved back closer to its pre-pandemic level, it still has further to go. If the rate increases at the pace that occurred in the first half of this year, it would not return to its pre-pandemic level until August/September at the earliest, which would certainly narrow the window for two rate hikes next year. The bar for the Fed’s unemployment rate criterion is also high enough that betting on two rate hikes next year appears excessive. Table 3 presents the average monthly jobs growth needed to reach an unemployment rate of 3.8% at different points over the next year. This highlights that a meaningful and sustained acceleration in jobs growth is required for the Fed to raise interest rates in July. Table 3Calculating The Time To Maximum Employment OUTLOOK 2022: Peak Inflation – Or Just Getting Started? OUTLOOK 2022: Peak Inflation – Or Just Getting Started? Mr. X: But these projections are based on the overall participation rate, and we have seen a surge in retirements during the pandemic. Doesn’t that mean that the unemployment rate will fall faster than the Fed currently expects, and that investors are right to move up their rate hike expectations? BCA: We have seen a huge increase in the number of retirees, and you are correct that a more rapid reduction in the unemployment rate could occur if pandemic retirements turn out to be “sticky”. However, we would point to two facts that suggest at least a portion of the surge in retirements will reverse. Chart 36Retirements Have Significantly Overshot Their Demographic Trend Retirements Have Significantly Overshot Their Demographic Trend Retirements Have Significantly Overshot Their Demographic Trend First, the surge in retirement during the pandemic is more than what would be implied by underlying demographic trends. Chart 36 shows that while the share of the US population that is retired has been steadily rising, it is now significantly above its 2010-2019 trend. Second, a recent study from the Kansas City Fed suggests that the non-demographic component of the recent surge in retirements has mainly been driven by a decline in the number of retirees rejoining the labor force,5 a phenomenon that we would expect to reverse as the pandemic abates. If the Omicron variant turns out to be threatening to the health of the older population even if they have been vaccinated, then we would not expect retiree reentry into the labor force until variant-specific booster shots are available. Chart 37Investors Expect The ECB To Lag The Fed, And We Agree Investors Expect The ECB To Lag The Fed, And We Agree Investors Expect The ECB To Lag The Fed, And We Agree Uncertainty over the status of retired workers is why we believe the Fed will focus on the working-age participation rate in judging whether the labor market has returned to a state of maximum employment. If the unemployment rate falls more quickly than expected because of a retiree-effect on the overall participation rate, the Fed will then turn to the working-age participation rate to judge the extent of labor market slack. It is only if non-supply driven wage growth is excessive and/or long-dated inflation expectations move sharply higher that the Fed will move in line with current market pricing. Mr. X: What about the ECB? Do you expect any monetary policy tightening in the euro area in 2022? BCA: Chart 37 highlights that investors had previously been expecting the ECB to raise interest rates once next year, lagging the Fed by roughly one rate hike. These expectations have been dialed back recently in response to the COVID situation in Europe as well as the news about Omicron. Chart 38Euro Area Inflation Is Not Broad-Based Euro Area Inflation Is Not Broad-Based Euro Area Inflation Is Not Broad-Based We agree that the ECB will raise rates after the Fed does, but we do not think that a euro area rate hike will occur next year – even once the pandemic situation improves. As is the case for the Fed, investors had been expecting that the ECB will be forced to respond to very elevated inflation. But Chart 38 highlights that euro area core inflation is barely above 2%, and panel 2 makes it clear that the rise in core euro area prices is not broad-based. This underscores that much of the rise in euro area prices is driven by commodities and problems with the global supply chain, neither of which will be fixed by higher euro area interest rates. As such, we agreed with ECB President Christine Lagarde’s pushback against market expectations for a rate hike next year, barring a much faster labor market recovery in advanced economies than we currently expect. Bond Market Prospects Mr. X: Thank you. Our monetary policy discussion serves as an excellent segue to the bond market outlook, and a question that I have been eager to pose to you. I find it astounding that long-maturity government bond yields remained so low this year given the longer-term inflationary risk, and given recent bets that central banks would be forced to move earlier than they had previously anticipated. Even if those bets unwind as a result of Omicron, I would like an explanation of what kept bond yields so low this year. In particular, I would like you to share your thoughts about what could cause bond yields to eventually react to the potential for higher inflation? Chart 39Investors, And The Fed, Continue To Subscribe To The Secular Stagnation Narrative Investors, And The Fed, Continue To Subscribe To The Secular Stagnation Narrative Investors, And The Fed, Continue To Subscribe To The Secular Stagnation Narrative BCA: The behavior of long-maturity government bonds this year reflects the view of both the Fed and market participants that the neutral rate of interest (“R-star”) remains very low relative to the potential growth rate of the economy (Chart 39). According to the Federal Reserve’s Statement on Longer Run Goals And Monetary Policy Strategy, the FOMC “judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average.” Bond investors agree with the Fed’s view, bolstered by previously low academic estimates of the neutral rate of interest such as those presented by the Laubach-Williams model. We agree that R-star fell in the US for a time following the Global Financial Crisis (GFC), but it is far from clear that it remains as low as the Fed and investors believe. The neutral rate of interest fell during the first half of the last economic cycle because of a persistent period of household deleveraging and balance-sheet repair, which was a multi-year consequence of the financial crisis and the insufficient fiscal response to the 2008-09 recession. Academic estimates of R-star are misleading,6 and it is clear that US household balance sheets are now in a much better state than they were in the lead-up to the GFC. Debt to disposable income for US households has fallen back to 2001 levels (Chart 40), the ratio of total liabilities to net worth has fallen meaningfully for most income categories (panel 2), and the household debt service ratio is now the lowest it has been since the 1970s (Chart 41), underscoring the capacity of US consumers to withstand higher interest rates. It is true that the US corporate sector leveraged itself over the course of the last economic cycle, but at least some of this increase in debt has served to fund capital structure changes, rather than the accumulation of a large stock of “deadweight” excess capacity. Chart 40US Household Balance Sheets Are In Far Better Shape Than They Used To Be US Household Balance Sheets Are In Far Better Shape Than They Used To Be US Household Balance Sheets Are In Far Better Shape Than They Used To Be Chart 41The US Household Debt Service Burden Is At A 40-Year Low The US Household Debt Service Burden Is At A 40-Year Low The US Household Debt Service Burden Is At A 40-Year Low     Investors should certainly be on the lookout for signs that market expectations for “R-star” are rising, but it is not probable that this will occur before the Fed begins to normalize monetary policy. This means that the bond market outlook over the coming year is dependent on the market’s assessment of the timing and pace of Fed rate hikes. Ms. X: You noted earlier that you disagree with the bond market’s outlook for US rate hikes next year. What are the fixed-income portfolio implications of that view? BCA: It is possible that the Fed may begin raising interest rates as early as next summer, but this is only likely to occur if jobs growth meaningfully accelerates, the surge in net retirements during the pandemic is durably sticky (beyond any potential impact from the Omicron variant), or long-dated inflation expectations become unanchored. It is not likely to occur simply because actual inflation, driven significantly by supply-side factors, is elevated. Chart 42A Moderate Rise In US Long-Maturity Bond Yields Next Year A Moderate Rise In US Long-Maturity Bond Yields Next Year A Moderate Rise In US Long-Maturity Bond Yields Next Year For short-maturity bonds, the investment implications of this view are more focused on the real versus inflation components of yields, rather than the existence of major mispricing of 2-year Treasury yields. US government bond yields have risen both at the short- and long-end due to rising inflation expectations, and real yields have fallen. We expect a more significant rise in real than nominal yields over the coming year. As such, investors should sell 2-year inflation protection, which is currently pricing too tepid of a deceleration in the pace of advance of consumer prices. For 10-year US Treasurys, we expect that yields will rise to between 2-2.25% over the coming year, as the Fed moves towards eventual rate hikes. Chart 42 presents FOMC-implied fair value estimates for the 2-, 5-, and 10-year Treasury yield, and underscores that bond yields are set to moderately rise next year. We are uncomfortable with the Fed’s projection of a permanently lower neutral rate of interest, but we see no evidence yet that surging inflation is changing the market’s assessment of the long-run average Fed funds rate. So for now, we recommend that fixed-income investors maintain a short-duration stance, but we do not expect a very severe rise in yields at the long-end of the curve next year. Ms. X: And what positioning would you recommend within a global fixed-income portfolio? BCA: The likely sequencing of central bank rate hikes over the coming 12-18 months suggests that global fixed-income investors should maintain an underweight stance towards US, UK, Canada, and New Zealand, and an overweight stance towards Japan, Europe, and Australia. Among our overweight recommendations, our view that the ECB will lag the Fed makes a clear case to be overweight euro area versus US bonds (both core and periphery), and Chart 43 highlights that rising US bond yields have been strongly correlated with the outperformance of euro area government bonds in US$ hedged terms over the past five years. For Japan, long-maturity JGB yields are likely to remain flat over the next year as they have been since 2016, underscoring that our allocation to JGBs is a strict function of our global duration call (with a short duration stance favoring Japan). In Australia, expectations for monetary policy have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. While there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth and inflation for the RBA to credibly remain on the sidelines next year. As such, we recommend that investors fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Among our underweight recommendations, the fact that the BOE is likely to be the next major developed economy central bank to raise interest rates supports a reduced allocation to UK government bonds. Relative to global government bonds, long-dated gilts have recovered somewhat from their earlier selloff in anticipation of a rate hike in early November, but we expect renewed underperformance in 2022. Unlike in the US, long-dated UK inflation expectations are meaningfully above their average of the past 15 years (Chart 44), which is motivating the BOE’s hawkishness. In Canada, the labor market has fully recovered the jobs lost during the pandemic, and the BOC has grown very concerned about the housing market and the potential for low interest rates to further inflate an already excessive amount of household sector debt. We expect a first rate hike from the BOC in the first half of 2022. Chart 43Rising US Treasury Yields Translates To Hedged Euro Area Government Bond Outperformance Rising US Treasury Yields Translates To Hedged Euro Area Government Bond Outperformance Rising US Treasury Yields Translates To Hedged Euro Area Government Bond Outperformance Chart 44UK Long-Term Inflation Expectations Are Not Contained UK Long-Term Inflation Expectations Are Not Contained UK Long-Term Inflation Expectations Are Not Contained Finally, a rate hike cycle has already begun in New Zealand, which also has an important link to the housing market. The New Zealand government has altered the remit of the Reserve Bank of New Zealand (RBNZ) to more explicitly factor in the impact of monetary policy on housing costs, suggesting that the RBNZ will prove to be one of the most hawkish central banks in the developed world over the next couple of years as the central bank attempts to cool off housing demand. Chart 45Speculative-Grade Corporate Bonds Offer Better Value Speculative-Grade Corporate Bonds Offer Better Value Speculative-Grade Corporate Bonds Offer Better Value Ms. X: Given the reality of low government bond yields globally, corporate credit has become an increasingly important part of our fixed-income portfolio. My father and I have noticed that corporate bond spreads are very low; should we be making any changes to our allocation to corporate credit? The combination of above-trend economic growth and accommodative monetary policy provides strong support for corporate bond spreads. However, US investment-grade corporate bonds offer essentially no value, and we advise investors to seek out higher returns in speculative-grade corporates. The 12-month breakeven spread for US investment-grade bonds is currently at its 2nd historical percentile (Chart 45), and we currently expect excess returns for IG corporates versus duration-matched Treasuries to be capped at 85 bps. For US high-yield bonds, we recommend an overweight stance within a fixed-income portfolio. We estimate that spreads are currently pricing an expected default rate of 3.1%, assuming a 100 bps risk premium and a 40% recovery rate on defaulted debt. Based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we model that the 12-month default rate will stay between 2.3% and 2.8% next year, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first ten months of this year, well below the estimate generated by our model. The accommodative monetary backdrop provided by the Fed will start to shift at some point in 2022. For now, an elevated 2/10 Treasury slope 85-90 bps suggests that monetary conditions are still accommodative, and our prior work suggests that corporate bond returns are typically strong when the slope is above 50 bps. But when the slope breaks below 50 bps, which could happen as soon as the first half of 2022, we will likely turn more defensive on corporate bonds. A flatter curve suggests a more neutral monetary backdrop, and with valuations already tight it will make sense to take some money off the table. The shifting US monetary policy backdrop leads us to favor European high-yield over US equivalents, as the ECB will be more dovish than the Fed next year. From a fundamental perspective, default rates are projected to be a bit lower in Europe in 2022 (around 2%) compared to the US, in an environment of solid nominal corporate revenue growth and still-moderate borrowing rates. Although valuations are hardly cheap on either side of the Atlantic, we do see better relative value in Ba-rated European junk bonds over similarly rated US credits. 12-month breakeven spreads for European Ba-rated high-yield are in the 38th percentile of its historical distribution, while US Ba-rated junk sits in the 24th percentile. Equity Market Outlook Mr. X: Thank you for your bond market comments. My view that bond yields have potentially much further to rise over the coming few years suggests that we will earn very little in the way of returns from our fixed-income portfolio, but the equity market outlook is no better. In fact, the medium-to-long term equity outlook is probably the worst that I have seen in a long time. Next year’s outlook is arguably bad as well; equity valuation is extreme, and you are forecasting a rise in long-maturity bond yields next year. In addition, you acknowledge that the longer-term term risks of inflation have risen, and believe that the Fed and investors are underestimating the neutral rate of interest. All of that seems wildly bearish to me! Chart 46US Revenue Growth Will Be Stout In 2022... US Revenue Growth Will Be Stout In 2022... US Revenue Growth Will Be Stout In 2022... BCA: Let’s address the longer-term outlook for stocks in a moment, and for now focus on what is likely to occur next year. Since the US equity market now accounts for 60% of global stock market capitalization, we will outline our US equity views first before turning to the rest of the world. The starting point for any cyclical view of the stock market should be one’s earnings outlook, and based on our economic view we agree with analyst expectations that US revenue growth will remain elevated next year relative to what has prevailed on average over the past decade (Chart 46). Above-trend growth and consumer price inflation point to revenue growth in the high single-digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, US profit margins have already risen to a new high both for the tech sector (broadly-defined) and ex-tech (Chart 47), and there are credible arguments in favor of an outright contraction in margins over the coming year.7 As such, we expect earnings growth to come in at or below revenue growth, which is currently expected to be about 7% next year. You referenced extreme overvaluation of the equity market, and Chart 48 highlights that the S&P 500 12-month forward P/E ratio is indeed now as high as it was during the stock market bubble of the late-1990s. But panel 2 of Chart 48 highlights that our proxy for the US equity risk premium (ERP) is in line with its historical average, in stark contrast to the lows that were reached in the late-1990s. Chart 47...But Profit Margins Are Extremely Elevated And May Fall ...But Profit Margins Are Extremely Elevated And May Fall ...But Profit Margins Are Extremely Elevated And May Fall Chart 48US Equity Multiples Are Extremely High, But The ERP Is Normal US Equity Multiples Are Extremely High, But The ERP Is Normal US Equity Multiples Are Extremely High, But The ERP Is Normal Chart 49Equity Multiples Are High Because Interest Rates Are Extremely Low Equity Multiples Are High Because Interest Rates Are Extremely Low Equity Multiples Are High Because Interest Rates Are Extremely Low These seemingly contradictory perspectives are resolved by the observation that real bond yields are extremely low today. It is reasonable to expect a structural decline in real bond yields over time given a structural decline in the potential growth rate of the economy, but Chart 49 highlights that real long-maturity yields are already substantially lower than estimates of trend growth. If we believed that real US government bond yields were set to rise by 200 basis points over the coming year, we would be categorically bearish towards stocks as it would imply a substantially lower P/E ratio. That, however, is very unlikely to occur while the Fed and investors subscribe to the secular stagnation narrative. While R-star is probably higher than the Fed and investors think, we do not think that these expectations will change before the Fed begins to normalize monetary policy. As such, while equity multiples may fall over the coming year in response to somewhat higher bond yields, we expect the decline to be relatively modest. Putting this all together, given our base case view that the pandemic will recede in importance next year, we expect mid-to-high single-digit returns from US equities in 2022 – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Mr. X: You showed the equity risk premium over the past 40 years, which was a period of rising financialization. Given the complacency that I see in markets, especially about the longer-term outlook, I strongly question the view that investors are demanding a normal premium as compensation for potential future volatility. Do your conclusions hold up if you use a much longer time horizon? BCA: They do. Chart 50 shows a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset. This indicates that the ERP today is in line with its long-term median. We do not use the cyclically-adjusted P/E ratio in this calculation; Chart 50 is simply calculated as the 12-month trailing reported earnings yield minus the real long-maturity bond yield. The chart shows that the ERP was quite low in the late-1990s, and above average for several years following the Global Financial Crisis. The conclusion is that while the US P/E ratio is extremely high today, it is so for a very different reason than what occurred in the late-1990s. At that time, the equity risk premium was extremely low, whereas today equity multiples are high because of very low interest rates. You asked about the longer-term outlook for stocks, and Chart 51 presents a range of possible 10-year total returns for US equities, based on a 100-200bps rise in real long-maturity bond yields and revenue growth on the order of 4-5% per year. These scenarios also assume flat profit margins, a constant 2% dividend yield, and a constant ERP. Chart 50The US Equity Risk Premium Is Normal Even Based On 150 Years Of History The US Equity Risk Premium Is Normal Even Based On 150 Years Of History The US Equity Risk Premium Is Normal Even Based On 150 Years Of History Chart 51 These returns projections, on the order of 2-5% per year, would beat the returns offered by bonds and thus argue that investors should still be structurally overweight equities versus fixed-income assets. But they would also fall short of the absolute return goals of many investors, and thus we agree that the longer-term outlook for stocks is poor – unless the ERP falls dramatically as real interest rates rise. That would be calling for a return to the ebullient conditions of the late-1990s, and we struggle to envision how this could occur given the myriad economic and geopolitical risks today that did not exist at that time. Ms. X: I want to address the two important global equity calls that did not pan out quite how you expected when we spoke last year: regional equity allocation and value versus growth. What is your view about these positions in 2022? BCA: Financials did modestly outperform broadly-defined technology stocks in 2021, so elements of the value versus growth trade did pan out. But using the MSCI value and growth indexes as benchmarks, value did underperform, and the relative performance of global value versus growth this year has been strongly linked to the 30-year Treasury yield. This has not always been the case in the past, but this year very long-maturity bond yields have done a very good job at explaining the relative performance of value (Chart 52). In addition, Chart 53 highlights the strong correlation between the relative performance of the US equity market and the relative performance of growth since the onset of the pandemic, which is explained by the US’s comparatively large weighting in broadly-defined technology stocks. Chart 52Global Value Versus Growth Is Strongly Correlated With Interest Rates Global Value Versus Growth Is Strongly Correlated With Interest Rates Global Value Versus Growth Is Strongly Correlated With Interest Rates Chart 53Growth / Value Is Impacting Regional Equity Performance Trends Growth / Value Is Impacting Regional Equity Performance Trends Growth / Value Is Impacting Regional Equity Performance Trends     Given our view that long-maturity bond yields are set to rise next year, we find it difficult to bet against value in 2022. At a minimum, a window exists for value’s outperformance, and we do recommend that investors overweight value versus growth next year. Considerable debate exists within BCA about the longer-term outlook for the trend in style, but for next year the majority of BCA strategists expect value to outperform at least for a time. Ms. X: And what about the performance of US stocks versus the rest of the world? BCA: The close link between growth / value and US / global ex-US stocks over the past two years suggests that the US will underperform at some point in 2022 relative to its global peers, although we acknowledge that this case is harder to make. The US did underperform global ex-US in the first quarter of 2021, and again from April to June, but the underperformance eventually gave way to substantial US outperformance. By contrast, the outperformance of global value vs. growth was more sustained in the first half of the year, and the reversal of that performance has been more closely aligned with the trend in bond yields. Our best answer as a firm is that investors should maintain a neutral allocation to the US versus global ex-US for now, with a bias towards increasing exposure to global ex-US at some point next year. Roughly 70% of global ex-US equity market cap is accounted for by DM economies, with the remaining 30% in emerging markets. Given our China economic view, it is difficult to make the case for EM stocks in the first half of 2022. We see more significant easing in China, potentially in Q2, is the most likely upgrade catalyst for EM. Within DM ex-US, the euro area is the most significant region by weight, and there are two arguments in favor of euro area outperformance at some point next year. First, Chart 54 highlights that euro area earnings have more post-pandemic catchup potential than US stocks, suggesting that the US may not fundamentally outperform other DM economies in 2022. Second, Chart 55 highlights that euro area stocks are the cheapest that they have been relative to the US since early-2009 and 2012. In both of these cases, the euro area subsequently outperformed US stocks. Chart 54Euro Area Earnings Have More Catch-Up Potential Euro Area Earnings Have More Catch-Up Potential Euro Area Earnings Have More Catch-Up Potential Chart 55Euro Area Stocks Are Extremely Cheap, And Have Rallied From Similar Valuation Levels Euro Area Stocks Are Extremely Cheap, And Have Rallied From Similar Valuation Levels Euro Area Stocks Are Extremely Cheap, And Have Rallied From Similar Valuation Levels     As an additional point about richly valued US equities, it has been argued that a premium is warranted for US stocks given their comparatively high return on equity. But Chart 56 illustrates that this is not the case. The chart shows the relative price-to-book ratio for the US versus developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to other developed markets, underscoring that US stocks are expensive above and beyond what fundamental performance appears to justify. That perspective is echoed in Chart 57, which highlights that the US 12-month forward P/E ratio is 50% above that for global ex-US stocks. Chart 56The Premium Paid For US Stocks Is Not Justified By Higher Return On Equity The Premium Paid For US Stocks Is Not Justified By Higher Return On Equity The Premium Paid For US Stocks Is Not Justified By Higher Return On Equity Chart 57US Stocks Are Extremely Expensive, No Matter How You Slice It US Stocks Are Extremely Expensive, No Matter How You Slice It US Stocks Are Extremely Expensive, No Matter How You Slice It Given the news about Omicron, and the recent spike in COVID cases and natural gas prices in the euro area, it may be too early to position in favor of DM ex-US stocks versus the US. But a shift from US to global ex-US stocks should be on investors’ watch list for 2022. Chart 58Industrials Are Likely To Outperform Next Year Industrials Are Likely To Outperform Next Year Industrials Are Likely To Outperform Next Year Mr. X: What about sector positioning, and small caps? BCA: Cyclical sectors have significantly outperformed defensives this year, and we expect further outperformance in 2022. Defensive sectors tend to underperform when bond yields are rising, and we expect that certain cyclical industries will continue to outperform next year. In particular, banks tend to outperform the broad market when interest rates are rising, pent-up demand will boost the consumer services and automobile industries within consumer discretionary, and industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders (Chart 58). Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently. We will discuss our commodity views in a moment, but we expect flat oil prices next year, and our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year. While we generally favor cyclical sectors next year, Chart 59 highlights that the trend in the performance of cyclicals versus defensives (shown in equally-weighted terms) has moved well past its pre-pandemic level, and is now challenging its early-2018 high. Cyclicals have further room to move higher when compared with the levels that prevailed in 2010-2011, but that period reflected resource price levels that we do not expect over the coming year. As such, the performance of cyclicals is getting somewhat late, and we expect to rotate away from cyclical sectors at some point over the coming year. In terms of capitalization, Chart 60 highlights that investors should favor small cap stocks versus large caps over the coming year. The chart highlights that the relative performance of global small caps had rebounded to its pre-trade war levels earlier this year, before falling anew in response to the economic consequences of the Delta wave of COVID-19 and the decline in government bond yields. Abstracting from longer-term trends, small cap stocks tend to outperform large caps over 1-year periods when bond yields are rising, and this has been especially true over the past decade (middle panel). Chart 59Cyclicals Have Some Room To Move Higher Versus Defensives, But Not Much Cyclicals Have Some Room To Move Higher Versus Defensives, But Not Much Cyclicals Have Some Room To Move Higher Versus Defensives, But Not Much Chart 60Favor Small Caps Over Large Caps In 2022 Favor Small Caps Over Large Caps In 2022 Favor Small Caps Over Large Caps In 2022   Our view that government bond yields are set to rise next year, in combination with very attractive relative valuation (bottom panel), makes an overweight small cap stance one of our highest conviction positions with an equity allocation. Currencies And Commodities Mr. X: You mentioned earlier that you expect oil prices to be essentially unchanged next year from the levels that prevailed prior to the discovery of the Omicron variant. I would appreciate it if you could provide the basis for that view, and also your perspective on natural gas prices given how significantly that market is affecting the European economy. Chart 61We Expect Oil To Trade At -81/Bbl Next Year, On Average We Expect Oil To Trade At $80-81/Bbl Next Year, On Average We Expect Oil To Trade At $80-81/Bbl Next Year, On Average BCA: Let’s deal first with crude oil prices. First, it should be noted that we will not have good information on Omicron’s impact on oil demand for a few more weeks, which makes it difficult to assess demand for next year as a whole. Prior to this news, our ensemble supply and demand estimates for crude oil projected an increase in supply from core OPEC 2.0 producers in 2022, on target to return to pre-pandemic levels around the middle of the year. Production from non-core OPEC producers will likely be flat to modestly down, consistent with the downward trend that has been in place over the past decade. On the demand side, our base case view suggests flat-to-modestly higher consumption growth in the DM world, and a pickup in non-OECD demand around the middle or back half of the year. Chart 61 highlights that the net result of these forecasts implies that brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. Geopolitical tension with Iran will most likely persist next year, which contributes to upside risk to our forecast. Clearly, Omicron contributes to downside risk. The fact that spot oil prices are likely to be flat next year does not mean that investors cannot profit from energy-related positions. Chart 61 also highlighted that the oil market is currently backwardated, with a downward sloping forward curve that is below our projected spot price for most of 2022. This means that investors can still profit from the roll yield, and we are comfortable recommending the pursuit of a dynamic roll strategy focused on energy contracts (such as the COMT ETF). On the natural gas front, we expect that spot prices will remain elevated through the winter, especially in Europe. The US Climate Prediction Center maintains 90% odds that La Niña will continue through the winter in the Northern Hemisphere, implying a colder-than-normal winter and thus higher-than-normal natural gas demand. Russia’s restriction of supply for geopolitical advantage can continue well in 2022. Chart 62 highlights that European natural gas storage is well below that of previous years, which has contributed to the almost 400% rise in prices this year. European natural gas prices are rising in part due to competition from China because of its power shortage, and are likely to remain high through the winter. Aside from higher-than-average temperatures through the winter months, a reduction in US import demand is the most likely catalyst for lower natgas prices in Europe. The Nord Stream 2 pipeline is unlikely to begin operations early enough to provide relief in H1 2022, although it is possible. Ms. X: One question that I have about the commodity outlook pertains to China. We discussed earlier how China’s economy has slowed this year, and yet metals prices remain in an uptrend. That seems like an aberration, and we would appreciate your thoughts on what is driving the disconnect. BCA: The behavior of industrials metals prices has indeed been confusing for many investors given the slowdown in Chinese economic activity, as evidenced by Chart 63. The annual growth rate of the Bloomberg Industrial Metals Spot Index remains surprisingly elevated given slowing economic activity in China and a meaningful decline in China’s credit impulse. Chart 62 Chart 63Metals Prices Are Seemingly Too High Given A Slowing Chinese Economy Metals Prices Are Seemingly Too High Given A Slowing Chinese Economy Metals Prices Are Seemingly Too High Given A Slowing Chinese Economy   What is missing from this picture is the fact that base metals inventories are very low, due in part to reduced refining activity in China. Charts 64 and 65 present two perspectives on copper inventories: the difference between global production and consumption of refined copper, and the level of warehouse and stock inventories tied to commodity exchanges. Both charts show that inventories have been drawn down heavily this year. Chart 64Global Metals Inventories Have Been Drawing Heavily This Year… Global Metals Inventories Have Been Drawing Heavily This Year... Global Metals Inventories Have Been Drawing Heavily This Year... Chart 65…And Exchange Inventories Are Very Low ...And Exchange Inventories Are Very Low ...And Exchange Inventories Are Very Low     Our expectation that China is likely to slow further over the coming few months arrayed against low metals inventories suggests that the Q1 outlook for metals prices is murky. But as we noted earlier, we expect a reacceleration in Chinese economic activity in the back half of 2022, implying that base metals prices are likely to be higher in 2022 on average. Over a multi-year horizon, we are quite bullish towards base metals – copper in particular – given the critical role that these metals will play in the push to decarbonize the global economy.8 Base metals capex will have to increase at the mining and refining levels to meet renewables and EV demand, and policymakers will need to work towards diversifying metals' production and refining to reduce the concentration risks that currently exist. We strongly suspect that higher prices will have a role in incentivizing higher base metals production, meaning that longer-term investors should follow a “buy copper on dips” strategy. Mr. X: You noted at the outset that gold fell in nominal terms this year, which was surprising to me. My expectation is that gold would have performed better than it did during a year with the strongest inflation in three decades. You referenced the dollar and real interest rates as drivers of the price of gold; please elaborate on that if you can, and what you expect to see from gold in 2022. BCA: It is not particularly surprising to us that the price of gold has fallen this year in the face of surging inflation. We agree that precious metals are a good hedge against inflation over the very long term, but over the cyclical investment horizon the volatility of gold vastly exceeds that of consumer prices. On this point, a comparison to the stock market is apt. It is often the case that changes in P/E ratios are the dominant drivers of equity returns over 6-12 month periods, and in the case of gold it is almost always the case that the real price of gold determines cyclical returns – not changes in the price level. Chart 66Gold Prices Likely Already Reflect An Expectation Of Rising Real Bond Yields Gold Prices Likely Already Reflect An Expectation Of Rising Real Bond Yields Gold Prices Likely Already Reflect An Expectation Of Rising Real Bond Yields Chart 66 highlights that real gold prices have been explained over the past 15 years by changes in the US dollar and especially real 10-year Treasury yields. The chart shows that gold prices are modestly lower today than this historical relationship would imply, possibly reflecting investor unease about the potential for monetary policy tightening next year (above and beyond what is currently reflected by real 10-year yields). Our view that real 10-year yields are likely to rise next year is thus ostensibly bearish for gold, but Chart 66 suggests that some of this effect may already be reflected in prices. As such, we expect that gold prices will be flat-to-modestly down, with the caveat that we would be aggressive buyers on any signs that one or more of today’s major geopolitical risks is materializing (e.g., conflict in the Middle East, Russia’s periphery, or China’s periphery). Chart 67Real Gold Prices Are Extremely Elevated Relative To Their History Real Gold Prices Are Extremely Elevated Relative To Their History Real Gold Prices Are Extremely Elevated Relative To Their History Over the longer term, Chart 67 highlights that real gold prices are extremely elevated relative to their history. This largely reflects the fact that real interest rates are well below trend rates of economic growth. As such, we are bearish towards gold prices over the secular horizon, given our expectation that real interest rates are likely to move higher over the longer-term. Ms. X: What is your outlook for the US dollar next year? BCA: We recommend that investors stick with short US dollar positions for 2022. However, we acknowledge that the dollar may remain strong over the coming few months, which may persist as long as investors expect near-term economic weakness in the euro area. The Omicron variant impact on global travel, surging COVID cases, and European natural gas prices will likely cause negative near-term economic surprises, but we do not expect these conditions to last over the coming 12 months. Chart 68EUR-USD Is Pricing Too Much Of A Widening In Real Bond Yield Differentials EUR-USD Is Pricing Too Much Of A Widening In Real Bond Yield Differentials EUR-USD Is Pricing Too Much Of A Widening In Real Bond Yield Differentials Versus major currencies, the broad trend in the dollar tends to be dominated by the USD-EUR exchange rate, and the recent collapse in the euro has contributed to the broad-based rise in the dollar. Chart 68 highlights that the euro area / US real 10-year government bond yield differential has done a good job of predicting the EUR-USD exchange rate since the Global Financial Crisis, and the chart highlights that the euro has fallen 5% below what this relationship would imply. Using Chart 68 as a guide, current pricing of the euro suggests that investors expect a 40 bps decline in the real 10-year yield differential. We expect US long-maturity real yields to rise on the order of 60-70 bps over the coming year, but the recent behavior of the euro is only fair if euro area real yields are mostly unchanged next year. We would bet against such an outcome, as the economic conditions that will eventually cause the Fed to raise interest rates also imply better economic outcomes for the euro area. Chinese economic growth is likely to be better in the second half of next year, which will boost global growth, and euro area consumers also have ample savings at their disposable to support consumer spending. The fact that euro area stocks have more earnings upside relative to pre-pandemic levels also argues against the dollar from the perspective of equity portfolio flows. Chart 69US Dollar And Indicator The US Dollar Is Overbought US Dollar And Indicator The US Dollar Is Overbought US Dollar And Indicator The US Dollar Is Overbought Three additional factors support a bearish dollar view beyond a near-term period of temporary dollar strength. The first is that the Fed is likely to lag the Bank of England and Bank of Canada in terms of moving towards normalizing monetary policy, a bearish outlook for USD-GBP and USD-CAD. The second factor is that the US dollar is normally a counter-cyclical currency, and recent dollar strength is implying a degree of equity market weakness that we do not expect next year. Third, Chart 69 highlights that the US dollar is on the verge of entering extremely overbought territory, underscoring that euro bearishness is likely overdone. Mr. X: My daughter and I have been debating adding cryptocurrencies to our portfolio. As you might guess, she sees promise in cryptos, whereas I see them as a bubble waiting to burst. What are your thoughts? BCA: We have had a similar debate at BCA. There is little doubt that the blockchain technologies underpinning cryptocurrencies are here to stay. The only question is whether cryptocurrencies themselves are worth investing in. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.1 trillion, equal to the entire stock of US dollars in circulation. The easy profits in this sector have already been made. Then there is the issue of competition. Many new cryptocurrencies have emerged on the scene since Bitcoin was invented more than a decade ago. Ethereum is the best known, but others such as Solana, Cardano, XRP, and Polkadot are arguably technologically superior. If one invests in this space, at a minimum, one should buy a basket of cryptos, similar to what one would do if one were betting on a new technology but did not know which specific company would ultimately prevail. Mr. X: What about regulation? Is it not just a matter of time before the hammer comes down on the whole sector? BCA: China has banned cryptos, but they continue to thrive, so the sector has proven itself quite resilient to government scrutiny. In fact, regulation could help cryptocurrencies gain the air of respectability, while attracting more institutional investment in the sector. The bigger issue is again, competition, but this time from central banks. Most major central banks are working to develop their own digital currencies. Also keep in mind that governments derive a lot of revenue from “seigniorage” – the ability to create money out of thin air. They would not want to lose that revenue. Mr. X: I am all in favor of depriving governments of the ability to print as much money as they want. But if I wanted to hedge this risk, I would buy gold. BCA: We are inclined to agree, with the caveat that gold itself is already expensive insurance against monetary debasement. Geopolitics Ms. X: I am not sure that I find your arguments about cryptocurrencies to be compelling, but I sense that this is a topic upon which we will have to agree to disagree – at least for now. Perhaps we can close out our discussion with your geopolitical outlook, and what risks my father and I should be most attuned to. Chart 70 BCA: As an overall summary of our view, we contend that the international system will remain unstable in 2022. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor, and is the first of three geopolitical themes that will persist next year and beyond. Multipolarity – or great power struggle – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China (Chart 70). China’s GDP has risen to the top in purchasing power terms and will do so in nominal terms in around five years. China’s potential growth is slowing and financial instability will be a recurring theme in 2022 and beyond. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Since China is ultimately capable of creating an alternative political order in Asia Pacific, the United States is belatedly reacting by penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. Russia and other nationalist powers are also drivers of multipolarity. Chart 71Hypo-Globalization, Our Second Geopolitical Theme Hypo-Globalization, Our Second Geopolitical Theme Hypo-Globalization, Our Second Geopolitical Theme The second geopolitical theme is “hypo-globalization,” in which globalization fails to live up to its potential. The trade intensity of global growth peaked with the Great Recession in 2008-10. The stimulus-fueled recovery in the wake of COVID-19 is seeing a trade rebound, which is positive for corporate earnings. But the upside will be limited by the negative geopolitical environment (Chart 71), which makes nations fearful of each other and hungry for self-sufficiency. The 2010s witnessed a retreat from globalization as developed economies saw private debt bubbles unwind, while emerging economies saw trade manufacturing unwind. Anti-globalization movements entered mainstream politics, in both democratic and authoritarian countries, from the East to the West. Today governments are not behaving as if they will engender a new era of ever-freer movement and ever-deepening international linkages. For example, the trade war between the US and China has morphed into a broader competition that limits cooperation to a few select areas, despite a leadership change in the United States. The further consolidation of central government power in China will exacerbate distrust. Chart 72The Risk Of Populism, Our Third Geopolitical Theme, Is Significant In Emerging Markets The Risk Of Populism, Our Third Geopolitical Theme, Is Significant In Emerging Markets The Risk Of Populism, Our Third Geopolitical Theme, Is Significant In Emerging Markets A third theme is populism, or anti-establishment political sentiment, which we discussed at length last year and is likely to escalate in 2022. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. Most of the developed markets have elected new governments since the pandemic, allowing voters to vent some frustration. But many of the emerging economies are either facing elections or have non-responsive political systems. Either way they may fail to address household grievances. This will be a source of social instability and economic uncertainty in the coming years. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and stands at 15% on average for the major emerging markets, up from around 13% in 2016. The same countries have stimulated their economies, feeding inflationary pressures (Chart 72). Just as the “Arab Spring” unrest destabilized the Middle East and North Africa in the years after the Great Recession, so will new movements destabilize this region or other regions in the wake of COVID-19. Regime failures lead to wars and waves of immigration, which in turn create larger policy changes that can impact markets. Ms. X: What are the investment implications of your geopolitical views? BCA: These three themes – great power struggle, hypo-globalization, and populism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism leads to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and inflation expectations, which is also possible. For example, China’s historic confluence of internal and external political risks has already led to growth disappointments and financial instability. A conflict over the Taiwan Strait, which cannot be ruled out, could begin with deflation and end in inflation, as wars often do. Chart 73 In this respect two geopolitical risks are worthy of repeating: Russia and Iran. Energy producers gain leverage as global energy supplies grow tight. That is why global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 73). This will most likely be the case in 2022. Both of these states are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. If these conflicts explode, they can lead to energy price shortages or shocks, which would clearly raise the odds of the stagflation-lite scenario that we described earlier. Conclusions Mr. X: Thank you very much for another interesting and thorough discussion of the outlook. Our discussion has not swayed me from my deep-seated concern that inflation over the medium-term will be much higher than investors think, and that there are likely to be enormous consequences from this for financial markets. You also acknowledged the long-term risk from a future rise in real interest rates – I suppose I simply see this risk materializing sooner than you do. Ms. X: Even if inflation is only moderately higher over the coming decade, say around 3% on average, that would still seem to have important implications for real portfolio returns. The main purpose of our meeting has been to discuss what will occur in 2022, but last year you provided us with long-term return projections across several asset classes compared with realized historical returns. An update to that would be very much appreciated. BCA: Table 4 presents an update of our long-term return projections based on a 3% inflation scenario, incorporating an allocation to alternative assets. As you highlighted, the projected real portfolio return is just 1% per year over the coming decade, compared with a 6.3% annualized historical real return. The table highlights an important dilemma for investors, which is that government bonds will offer very poor real returns over the coming decade if inflation is higher on average than it has been. Government bonds have traditionally been the core safe-haven assets in investor portfolios, underscoring that global investors may have to accept more volatility to achieve their desired return goals. In our view, this should come in the form of a reduced strategic allocation to US stocks within an equity portfolio, and an increased allocation to alternative assets such as real estate and alternative investments. Table 4Long-Term Return Scenarios In A World With 3% Inflation OUTLOOK 2022: Peak Inflation – Or Just Getting Started? OUTLOOK 2022: Peak Inflation – Or Just Getting Started? Ms. X: Thank you. In conclusion, could you summarize your main economic and investment views for 2022? BCA: It would be our pleasure. Our main points are as follows: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. The existence of effective anti-viral treatments, that are not affected by the virus’s mutation, should help limit the impact of Omicron on the medical system. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. Investors are overestimating the magnitude of inflation over the coming 12 months, and we expect actual inflation will come in lower next year than what short-maturity inflation expectations are currently suggesting. Economic growth in advanced economies will be above-trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the back half of next year than over the coming 6 months. China is currently a “one-legged” economy that is supported by external demand, and a shift in advanced economy consumer spending from goods to services may be the catalyst for more aggressive easing from policymakers. Stocks will outperform bonds in 2022, but equity market returns will be in single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may rise in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields – which will not threaten economic activity or cause a major decline in equity multiples. Fixed-income investors should maintain a short duration stance, and position for lower inflation expectations and higher real rates (especially at the short end of the curve). We recommend selling short-maturity inflation protection. Within a government bond portfolio, overweight Europe (core and periphery), Japan, and Australia. Underweight the US, UK, Canada, and New Zealand. Within a credit portfolio, favor speculative-grade over investment-grade corporate bonds, and European Ba-rated European junk bonds over similarly rated US credits. Equity investors should favor small cap over large cap stocks in 2022. Small cap stocks tend to outperform large caps over 1-year periods when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year, but stretched relative performance versus defensives means that we expect to rotate away from cyclical sectors at some point over the coming year. A window exists for value’s outperformance versus growth in 2022 in response to higher long-maturity government bond yields, and we do recommend the former over the latter. Investors should maintain a neutral allocation to the US versus global ex-US for now, with a bias towards increasing exposure to global ex-US at some point next year. An underweight stance towards EM stocks in 1H 2022 is appropriate until clearer signs of Chinese policy easing emerge. Within DM ex-US, we expect euro area outperformance at some point next year: euro area earnings have more post-pandemic catchup potential than US stocks, and relative valuation argues for a euro area bounce. Aside from the potential for Omicron-related near-term economic weakness, a shift in investor expectations for the terminal Fed funds rate is a risk that investors should monitor. Our judgement is that this will probably not occur before the Fed begins to normalize monetary policy. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The oil market is currently backwardated, meaning that investors should pursue a dynamic roll strategy focused on energy contracts. European natural gas prices are likely to remain high through the winter. Aside from higher-than-average temperatures through the winter months, a reduction in US import demand is the most likely catalyst for lower natgas prices in Europe. The outlook for base metals in the first half of 2022 is murky. Metals inventories are low, but China is likely to slow further over the coming few months. Our expectation of a reacceleration in Chinese economic activity in the back half of 2022 means that, on average, base metals prices will be higher in 2022. We expect that gold prices will be flat-to-modestly down next year, although we would be aggressive buyers on any signs that one or more of today’s major geopolitical risks is materializing (e.g., conflict in the Middle East, Russia’s periphery, or China’s periphery). The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. The international system will remain unstable in 2022. Multipolarity, “hypo-globalization”, and populism will remain important geopolitical themes next year (and beyond). The Editors December 1, 2021   Footnotes 1   “South African doctor who raised alarm about omicron variant says symptoms are ‘unusual but mild,” The Telegraph, November 27, 2021. 2   Please see The Bank Credit Analyst "In COVID’s Wake: Government Debt And The Path Of Interest Rates," dated April 29, 2021, available at bca.bcaresearch.com 3  Please see The Bank Credit Analyst "Work From Home “Stickiness” And The Outlook For Monetary Policy," dated June 24, 2021, available at bca.bcaresearch.com 4  June 2021, “Global Economic Impact Trends 2021”, World Travel & Tourism Council 5  What Has Driven the Recent Increase in Retirements? by Jun Nie and Shu-Kuei X. Yang, Federal Reserve Bank of Kansas City Economic Bulletin, August 11, 2021. 6  Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 7   Please see US Equity Strategy "Marginally Worse," dated October 11, 2021, available at uses.bcaresearch.com 8  Please see Commodity & Energy Strategy "COP26 Meets During Policy-Induced Crisis," dated October 28, 2021, available at ces.bcaresearch.com

Highlights There are a few consistencies with the dollar breakout. Global growth is peaking and the risk of a significant slowdown early next year has risen. As a momentum currency, further gains in the DXY remain very high in the near term. We are shifting our near-term target to 98 (previously 95). That said, the dollar is now close to pricing a global recession, which seems improbable given easy monetary settings and ample fiscal stimulus. High inflation is not a US-centric phenomenon but a global problem. This means that monetary policy in the US cannot sustainably diverge from other central banks. Correspondingly, low US TIPS yields do not confirm the breakout in the dollar. Even if the US 10-year Treasury yield rises towards 2.5%, real interest rates will remain very low compared to history and other G10 economies. While global growth will slow next year, we expect that it will remain robust. And if it rotates from the US to other countries, the dollar will have a very sharp reversal. Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Feature Chart I-1The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates After spending most of this year range bound between 89 and 94, the DXY index has broken out. The narrative has been centered around rising US inflation, which will trigger much faster interest rate increases from the Fed. This is consistent with recent economic data, where US inflation has indeed blown out, and is also rising at the fastest pace among G10 countries. What has been inconsistent is that US TIPS yields remain very low, and have diverged from the broad dollar trend (Chart I-1). One of the key structural drivers of currencies is real interest rate differentials. If the Fed does move ahead of the inflation curve and aggressively hikes interest rates, then US TIPS yields will rise and catch up with the dollar. Otherwise, the recent rise in the greenback could represent a capitulation phase that will quickly reverse should the inflationary mania subside. Consistencies With The Dollar Rise The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year (Chart I-2). Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent). The market suggests that compared to earlier this year, a 63bps spread difference is now warranted between US and European interest rates, while an 80bps difference is appropriate vis-à-vis Japanese rates. This shift perfectly explains the move in the dollar over the last few weeks (Chart I-3). Chart I-2Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Chart I-3A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally These market moves have been consistent with economic developments. Upside economic surprises in the US have dominated other G10 economies and supported the dollar (Chart I-4). The slowdown in China has been another hiccup in the global growth story. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is metastasizing into a genuine slump that will impact commodity import demand and hurt procyclical currencies liked the AUD (Chart I-5). Chart I-4Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Chart I-5A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD The slowdown is not unique to China. With new Covid-19 infections surging in various European countries, ex-US economic data is likely to remain underwhelming early next year. Within this context, the US economy remains relatively immune. Exports explain only 10% of US GDP. The IMF projects that the US is one of the first countries to close its output gap (Chart I-6). This will support a tighter monetary stance in the US, compared to other G10 countries. Chart I-6 Contradictions With The Dollar Rally There are a few contradictions with the dollar rally. First, the Fed is already lagging the US inflation curve. Various DM and EM central banks have calibrated monetary policy higher in response to rising inflation (Chart I-7). While the Fed might accelerate the pace of tapering asset purchases, other central banks in developed economies have already ended QE and are raising rates. At some point, relative monetary policies would matter for currencies, as has historically been the case. Since the start of the year, market pricing for higher rates according to the OIS curve has been lifted for most G10 countries (Table 1). Yet the dollar has rallied, while other currencies have collapsed (Chart I-8). Chart I-7Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Chart I- Chart I-8Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Second, part of that rally has been driven by speculative inflows, and not by underlying economic fundamentals. Net speculative positions in the US dollar are near levels that have usually signaled that the trade is becoming much crowded (Chart I-9). As we highlighted in Chart 1, this has occurred amidst very low nominal and real interest rates. But more importantly, as a reserve currency, the dollar enjoys the priviledge of being the safe-haven asset of choice. It is quite plausible that one of the key drivers of the rally has also been hedging by fund managers for an equity market correction (Chart I-10). Chart I-9Speculators Are Nearing Exhaustion ##br##Levels Speculators Are Nearing Exhaustion Levels Speculators Are Nearing Exhaustion Levels Chart I-10Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Third, inflation could indeed prove to be transitory. Our sister publication, the Commodity & Energy Strategy, suggests that metals and oil prices will remain well bid in the near term. Inflation however is about rates of change. Natural gas prices rose 100% this year while oil prices rose 60%. Market expectations are that these prices will roll over (Chart I-11). The Baltic Dry Index, a proxy for shipping costs and supply bottlenecks, initially rose 300% and is now down 53% from its peak. A middle ground where prices remain well bid but do not generate the same inflationary impulse next year seems most plausible. This will ease all market expectations for central bank hawkishness, but could sound the death knell for the dollar that has quickly moved to price in the current market narrative. Chart I-11Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Fourth, a strong US dollar hurts US growth. According to the Fed’s own estimates, a 10% rise in the dollar reduces US growth by 0.5% in the subsequent four quarters and 1.2% over two years. Meanwhile, a strong US dollar will certainly alleviate pressure on the Fed to fight inflation. A Counterpoint View To The Market Narrative Covid-19 will be with us for a while. As such, the volatility of growth forecasts around infection waves will subside. The remarkable thing is that despite fears of a global growth slowdown, there is a pretty robust expectation that the US will fare poorly relative to other developed markets in terms of growth next year. Countries such as Canada, New Zealand, the UK, and Japan are seeing a bottoming in growth momentum relative to the US (Chart I-12). For some, this is occurring at the same time as their local central banks are becoming more orthodox about monetary policy. As we have argued earlier, this is clear real-time evidence that the Fed will lag the inflation curve. Chart I-12AA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US Chart I-12BA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US One key signpost is China. It has tightened policy amidst very low inflation, and the traditional relationship between real rates and the RMB is working like a charm as the currency appreciates in trade-weighted terms. In a nutshell, currency markets tend to reconverge with real interest rate differentials over time. This will eventually be the case with the dollar (Chart I-13). Chart I-13Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Finally, China might marginally ease policy to sustain growth. In our view, China could stand pat since nominal bond yields are falling and exports are robust suggesting overall financing conditions are not a problem. But if this is a primate cause for fuelling long dollar bets, that will eventually hurt EM demand, China could also shift. This will be bullish for the dollar in the near term (it will require a riot point for China to shift), but bearish the dollar over a cyclical investment horizon, as commodity economies bottom. Investment Strategy Chart I-14Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession In the current environment, the DXY could hit 98. This will be consistent with a blowout in our capitulation index, as well an exhaustion of dollar bulls. That said, the dollar is now close to pricing a global manufacturing recession, which seems improbable given easy monetary settings and ample fiscal stimulus in most DM economies (Chart I-14). Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Finally, our agnostic trading model continues to suggest short dollar positions (Chart I-15). Admittedly, it is the valuation component driving the calibration, rather than sentiment or appreciation for the investment shift in the macro narrative. In our portfolio, we will sit on the sidelines until most of our intermediate-term indicators stage a reversal. Chart I-15AOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Chart I-15BOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist  Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week).  Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories.  While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes   Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist Low Copper Stocks Will Persist Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD  Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Base Metals Defy Strong USD Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Brent Prices Are Going Up... Brent Prices Are Going Up... Chart 10 ...As Well As Gold Prices ...As Well As Gold Prices   Footnotes 1     Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2     Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021.  3    Please see Precious Metals commentary in the Commodity Round-Up section. 4    The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables.  It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere.  Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion.   Investment Views and Themes Strategic Recommendations

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Weakening Loan Demand Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Housing Activities Are Still Falling Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Large Current Account Surplus Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance