Currencies

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

Highlights Recommended Allocation Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify  The global economy will continue to grow at an above-trend rate over the next 12 months and central banks will remove accommodation only slowly.But the second year of a bull market is often tricky: Growth slows after its initial rebound, and monetary policy starts to be tightened, amid rising inflation.Equities are likely to outperform bonds over the next 12 months, driven by improving earnings, but at a slower pace than over the past year and with higher volatility.We continue to recommend only a cautiously optimistic stance on equities, with an overweight in US equities, and underweight in Europe. Our sector overweights are a mix of cyclicals (Industrials), plays on higher rates (Financials), and selective defensives (Health Care).China is likely to announce a stimulus to cushion the impact from Evergrande, which might push up oversold Chinese stocks. We close our underweight on Chinese equities, but raise them only to neutral as the real estate sector looks vulnerable. That could be bad news for commodities and the rest of Emerging Markets, which we cut to underweight.The Fed is likely to announce tapering this quarter, and raise rates in December 2022. This is likely to push up 10-year Treasury yields to 2-2.25% by then, and so we remain underweight duration.Investment-grade credit is expensive, but B-rated high-yield bonds still look attractive as defaults continue to decline. EM corporate debt is riskier post-Evergrande, but higher-rated sovereign dollar debt offers a good spread pickup.OverviewThe second year of a bull market is often tricky. Growth starts to slow after its initial rebound, and central banks move towards tightening policy. This does not signal the end of the bull market, but equity returns in Year 2 are typically lacklustre (Table 1).That is exactly the situation markets face now. Growth has been surprising on the downside, and inflation on the upside over the past few months (Chart 1). Table 1Year 2 Of Bull Markets Often Has Only Weak Returns Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify   Chart 1Growth Surprising On The Downside, Inflation On The Upside Growth Surprising On The Downside, Inflation On The Upside Growth Surprising On The Downside, Inflation On The Upside  Our basic investment stance remains that the global economy will continue to grow at an above-trend rate over the next 12 months (as the consensus forecasts – Chart 2), and that central banks will remove accommodation only slowly. We can see no signs of a recession on the 18-to-24-month horizon and, as Chart 3 shows, equities almost always outperform bonds except during and in the run-up to recessions. Chart 2But Growth Will Continue To Be Above Trend But Growth Will Continue To Be Above Trend But Growth Will Continue To Be Above Trend   Chart 3Equities Outpeform Bonds Except Around Recessions Equities Outpeform Bonds Except Around Recessions Equities Outpeform Bonds Except Around Recessions  This justifies a moderately pro-risk stance, with overweights in equities and (selectively) credit, and a big underweight in government bonds. But the risks to this sanguine view are rising, and the next few months could be choppy. Stay bullish, but keep a close eye on what could go wrong.The slowdown in growth is largely because manufacturing boomed last year and now simply the pace of growth is decelerating. Manufacturing PMIs are (mostly) still above 50, but have fallen from their peaks (Chart 4). Supply-chain bottlenecks have also dented production. And consumers will spend less on durables and more on services, as lockdowns are eased.We have emphasized that the $2.5 trillion of excess savings in the US will boost spending over coming quarters. But enhanced unemployment benefits have now ended and most of the savings left are with richer households who have a lower propensity to spend (see page 9 for more on this). Covid also remains a risk: Cases are stickily high in some countries and consumers are still not 100% confident about going out to dine and for entertainment (Chart 5). Chart 4PMIs Falling But Mostly Still Above 50 PMIs Falling But Mostly Still Above 50 PMIs Falling But Mostly Still Above 50   Chart 5Consumers Still A Bit Wary About Going Out Consumers Still A Bit Wary About Going Out Consumers Still A Bit Wary About Going Out  China is an increasing risk to growth. Its economy has been slowing all year as a result of monetary tightening (Chart 6) and this may be exacerbated by the fallout from Evergrande. The Chinese authorities are likely to announce a stimulus package to offset the slowdown (which is why we are neutralizing our underweight on Chinese equities). But the stimulus will probably be only moderate and targeted, and they will not allow a renewed boom in real estate (as we explain on page 11), which has been a significant driver of Chinese growth in recent years (Chart 7). This could hurt the economies of Emerging Markets and other commodity producers, which depend on Chinese demand. Chart 6China Has Been Slowing All Year China Has Been Slowing All Year China Has Been Slowing All Year   Chart 7Real Estate Has Been A Big Driver Of Chinese Growth Real Estate Has Been A Big Driver Of Chinese Growth Real Estate Has Been A Big Driver Of Chinese Growth  At the same time that growth is slowing, inflation is proving a little stickier and broader-based than was expected. Measures of underlying inflation pressure, such as trimmed-mean CPIs, suggest that it is no longer only pandemic-related prices that are rising in the US and some other countries (Chart 8). Rising shipping charges (container rates are up 228% this year) are pushing up the cost of imported goods. And the first signs are emerging that labor shortages, especially in restaurants and shops, are causing wage rises (Chart 9). Chart 8Inflation Is Broadening Out In Some Countries Inflation Is Broadening Out In Some Countries Inflation Is Broadening Out In Some Countries   Chart 9The First Signs Of Wage Rises? The First Signs Of Wage Rises? The First Signs Of Wage Rises?  Unsurprisingly, then, central banks are starting to wind down their asset purchases and even raise rates. Norges Bank was the first developed central bank to hike this cycle in September. New Zealand may follow in Q4. And the Fed has pretty clearly signaled that it, too, will announce tapering before year-end. And this is not to mention Emerging Market central banks, many of which have had to raise rates sharply in the face of soaring inflation (Chart 10).A shrinking of excess liquidity is another common phenomenon of the second stage of expansions, as monetary policy starts to be tightened and liquidity is directed more towards the real economy and less towards speculation. This, too, often caps the upside for risk assets, though it doesn’t usually cause them to collapse (Chart 11). Chart 10EM Central Banks Raising Rates Sharply EM Central Banks Raising Rates Sharply EM Central Banks Raising Rates Sharply   Chart 11Excess Liquidity Is Drying Up Excess Liquidity Is Drying Up Excess Liquidity Is Drying Up   Table 2Who Will Raise Rates When? Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify  While there are many factors that might cause market jitters over the coming months, the underlying picture is that robust growth is likely to continue and central banks will remain cautious about tightening too quickly. Excess savings will propel consumption, companies will need to increase capex to fulfill that demand, and the impact of fiscal stimulus is still coming through (Chart 12). The big central banks won’t raise rates for some time: The Fed perhaps in late-2022, but the ECB and the Bank of Japan not over the forecast horizon (Table 2). Decent growth and easy policy remains a positive backdrop for risk assets over the 12-month horizon. Chart 12Fiscal Stimulus Is Still Coming Through Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify   Garry Evans, Senior Vice PresidentChief Global Asset Allocation Strategistgarry@bcaresearch.comWhat Our Clients Are AskingHow Worried Should We Be About Inflation?Since the beginning of the year, we have argued that the current period of high inflation will be transitory. The market has adopted this view, with 5-year/5-year forward inflation expectations remaining at 2.2%. Chart 13Growing Signs That Inflation Might Not Be Transitory Growing Signs That Inflation Might Not Be Transitory Growing Signs That Inflation Might Not Be Transitory  However, we have grown worried about the possibility that inflation might be stickier at a higher level than we initially expected. Specifically, while it is true that prices of supply-constrained items – such as used cars – have started to ease, there are signs that higher inflation has began to broaden. Core CPI excluding pandemic-related items and cars has started to pick up, with its 6-month rate of change reaching its highest level in more than a decade (Chart 13, panel 1). Meanwhile 42% of the PCE basket grew at an annual rate of more than 5% in July, compared to just 24% in March.Currently, we are watching the behavior of prices in the housing and labor markets to check if our worries are justified. We pay particular attention to these sectors because price pressures in housing and labor can be self-sustaining, giving rise to inflationary spirals if left unchecked.What is happening to inflation in these areas? So far, the signals are mixed. Even though wage growth remains within the historical norm for now, any further advance in wages will take us to a decade high (Chart 13, panel 2). Likewise, annual growth of shelter cost remains low, though its 6-month change suggests that it will soon begin to rise to its pre-pandemic levels (Chart 13,  panel 3).Our base case continues to be that high inflation is transitory. That being said, we have positioned our portfolio to hedge for the risk that this view is wrong. We have given an overweight to real estate in our alternatives portfolio and within equities. Will Consumers Really Spend All Those Savings? Chart 14Low-Income Households Did Not Save Much Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify  Generous unemployment benefits and the year-long lockdown have pushed up US excess savings over the past 18 months to an estimated $2.5 trillion, and the household savings ratio to 9.6% (Chart 14, panel 1). The consensus is that these savings will bolster consumer spending and support broad economic growth over the coming quarters. However, this expectation is based on the assumption that all consumers have accumulated savings, whereas the reality is a bit different.Survey results from the US Census Bureau show that households earning under $75,000, which have the highest propensity to consume, have almost entirely spent their first stimulus checks and three-quarters of their second and third checks on expenses and paying off debt. Even for those earning over $75,000, only 50% of those stimulus receipts have gone into savings (Chart 14, panel 2).With the labor market still not back to full employment (albeit mostly because of labor supply issues), enhanced unemployment benefits coming to an end, fears of further Covid variants and lockdowns, and higher inflation, could precautionary savings rise? The years following the Global Financial Crisis suggest that they might: The savings rate rose from 3% at the onset of the GFC to 8% five years after it (Chart 14, panel 3). A similar attitude among consumers this time could put a dent in US growth, given that consumption makes up about 70% of GDP.This raises the risk that consumption might slow over the coming quarters. In our latest Monthly Portfolio Outlook, we highlighted that consumption is shifting away from goods towards services. While value added from manufacturing is only 11% of GDP, the effect on markets might be bigger, since goods producers make up about 40% of US market cap. What Is The Risk Of A Big Upside Surprise In US Employment?The recovery of the labor market remains at the center of investors’ and Fed officials’ attention. The reluctance to return to the workforce mostly reflects overly generous unemployment benefits and fears of getting infected. With the fourth wave of the pandemic showing signs of cresting and benefits expiring, the consensus is that the unemployment gap will soon shrink. We would, however, question whether the labor market can surprise significantly to the upside and recover faster than the market currently implies. A swift recovery would push up bond yields and bring forward the Fed’s liftoff date, which could hurt the outlook for risk assets. Chart 15The Labor Market Could Surprise To The Upside The Labor Market Could Surprise To The Upside The Labor Market Could Surprise To The Upside  The number of men not in the labor force but who want a job has fallen back to the pre-pandemic level (Chart 15, panel 1). The sharp decline in this indicator in August coincided with the expiration of unemployment benefits in some Republican states. The overall Federal pandemic benefits program expired in early September. This should push even more people to return to the workforce (Chart 15, panel 2).However, there are still close to 3.5 million women (almost half a million above the pre-pandemic level) who are not in the labor force but would like a job: Some of these are keen to return to the workplace once they deem it safe for their children to get vaccinated and return to school. With governments eager to speed up vaccination rollouts and Pfizer’s recent announcement showing positive results of its Covid vaccine in trials on children under the age of 12, more women should return to the workforce.It is also worth noting that some of the most hard-hit sectors – such as leisure & hospitality – have already recovered over 80% of the jobs lost since February 2020. For sectors yet to reach such a high recovery rate, for example education & health services, returning workers have room to choose from jobs. For every job lost since the onset of the pandemic, there are now 2.1 job openings (Chart 15, panel 3). What Is The Risk Of Contagion From Evergrande?In September, Chinese property developer Evergrande failed to make an interest payment on an overseas bond issue. What would be the consequences for the Chinese and global economy if it went bankrupt? Chart 16Chinese Companies Are Highly Indebted Chinese Companies Are Highly Indebted Chinese Companies Are Highly Indebted  Evergrande is big. Its debts are $306 billion, 2% of Chinese GDP. It has yet to build 1 million units that have already been paid for. It employs 200,000 people. And the issue is bigger. For years, investors have worried about China’s corporate debt, which is 160% of GDP (Chart 16). Chinese companies have issued almost $1 trillion of bonds in foreign currencies. The property market plays an outsized role in the economy: It comprises 66% of household wealth (versus 24% in the US); real estate and related industries amount to some 30% of GDP.The government will likely rescue Evergrande. But it faces a dilemma: For years it has been trying to reduce bad debt and stabilize house prices. It cannot bail out Evergrande’s creditors without undermining those efforts.It will probably aid apartment buyers, who have paid upfront for Evergrande properties, and make arrangements for domestic banks to swap their debt for equity or land holdings. But it won’t bail out equity owners or foreign bond holders. It will also not ease real-estate market restrictions, such as the “three red line” rules on property companies’ leverage. Such a package could damage Chinese individuals’ confidence in property, and foreigners willingness to provide capital to the industry.China may also announce a stimulus package to bolster the economy. But local governments are dependent on land sales for around a third of their income (Chart 17). If the property market is weak, the transmission mechanism of stimulus may be damaged. Finally, Chinese housing sales are highly correlated to global commodities prices, which may fall as a result (Chart 18). Chart 17Local Governments Depend On Land Sales Local Governments Depend On Land Sales Local Governments Depend On Land Sales   Chart 18A Slowdown In Housing Would Hurt Commodities A Slowdown In Housing Would Hurt Commodities A Slowdown In Housing Would Hurt Commodities  BCA Research’s EM and China strategists do not see Evergrande as  likely to trigger a systemic crisis or crash, but it will reinforce the chronic credit tightening that has been underway in China.1Is It Time To Overweight Japanese Equities?Japanese equities staged a strong rally in the third quarter, outperforming the MSCI global equity index by about 5% in US dollar total return terms. On an absolute basis, the MSCI Japan price index in USD is near its 1989 historical high, even though the local-currency index is still more than 30% below its 1989 all-time high.We have been underweight Japanese equities in our global equity portfolio since July 2019, mainly due to unfavorable structural forces such as the aging population and chronic deflationary pressures. Japanese equities have tended to stage counter-trend bounces, some of which were quite significant in magnitude (Chart 19, panel 1). We therefore recommend clients move to the sidelines to avoid the potentially short-lived but sharp upside risk, supported by the following two considerations:First, foreign investors play a significant role in the Japanese equity market. The fact that MSCI Japan in USD terms is near its all-time high could trigger more foreign buying, given the positive correlation between the price index and price momentum (Chart 19, panels 3 and 5).Second, Japanese equities are among the cheapest globally, trading at a large discount to the global index. Currently, the discount is larger than its 3-year moving average, making it risky to underweight Japan.So why not overweight Japanese equities?The Japanese equity index is dominated by Industrials. It should benefit from our favorable view on this sector. However, Japan’s machinery and machine tool industries have heavy reliance on Asia, especially China. Orders from China have already rolled over with the Chinese PMI now in contractionary territory. In the meantime, the rolling-over of the US and European PMIs also does not bode well for orders from the other two large regions (Chart 20). Chart 19Upgrade Japanese Equities To Neutral Upgrade Japanese Equities To Neutral Upgrade Japanese Equities To Neutral   Chart 20Japan's Heavy External Reliance Japan's Heavy External Reliance Japan's Heavy External Reliance  We expect that China will eventually inject stimulus into its economy in a measured fashion such that the negative spillover to Japan and Europe may be limited. That’s why we are also taking profit in our underweight position on China after the recent sharp selloff in the offshore Chinese equity index (see page 18).Global EconomyOverview: The developed world continues to see strong growth, albeit at a slower pace than nine months ago. This is causing a more persistent – and more broad-based – rise in inflation, especially in the US, than was previously expected. However, the Fed is unlikely to raise rates for at least another 12 months, and the ECB and BOJ not on the forecast horizon. The biggest risk to global economic growth is the slowdown in China and now the troubles at Evergrande. We assume that the Chinese government will launch a stimulus to cushion the slowdown, but it may be less effective than the market expects. Chart 21US Growth Has Slowed But Remains Above Trend US Growth Has Slowed But Remains Above Trend US Growth Has Slowed But Remains Above Trend  US: Growth has been slowing relative to expectations all year (Chart 21, panel 1). Nonetheless, it is still well above trend. The September Markit PMIs remained high at 60.5 for manufacturing and 54.4 for services. Although consumer confidence has fallen back a little because of the third Covid wave in some southern states, retail sales in August were still up 15% year-on-year and 1.8% (ex autos) month-on-month. Growth seems set to remain above trend, as consumers spend their $2.5 trillion of excess savings, companies increase capex to ease supply-chain bottlenecks, and the government rolls out more fiscal spending. The IMF forecasts 4.9% real GDP growth in 2022, after 7.0% this year. Euro Area growth also remains robust, with the manufacturing and services PMIs at 58.7 and 56.3 respectively in September. Vaccination levels have risen (more quickly than in the US) and, as a consequence, lockdowns and international travel restrictions have been largely eased. Inflation pressures remain more restrained than in the US, with core CPI at only 1.6% (mainly pushed up by pandemic-related shortages) and the trimmed-mean CPI barely above zero. The ECB persuaded the market that its tapering, announced in September, is very dovish, and it is certainly true that – with its new 2% symmetrical inflation target – the ECB is not set to raise rates any time soon. The IMF’s forecasts are for 4.6% real GDP growth this year, and 4.3% next.Japan has generally lagged the recovery in the rest of the world, due to its structural headwinds, but it is now seeing some more robust data. Industrial production is up 12% year-on-year and exports 26%, although the PMIs still remain somewhat depressed at 51.2 for manufacturing and 47.4 for services in September. Japan’s initial slow vaccine rollout has recently accelerated and the percent of double-vaccinated adults now exceeds the US. This suggests that sluggish consumption (with retail sales up only 2% year-on-year) might start to recover. Markets got excited about the prospects for fiscal stimulus ahead of the general election, which has to be held by the end of November. We do not see new LDP leader Fumio Kishida, who is likely to win that election, making any significant change in policy. Chart 22China Is The One Market Where Growth Is Slowing Sharply China Is The One Market Where Growth Is Slowing Sharply China Is The One Market Where Growth Is Slowing Sharply  Emerging Markets: China’s slowdown – and the government’s possible reaction to it with a large stimulus – dominate the outlook for Emerging Markets. Both China’s manufacturing and services PMIs are now below 50 (Chart 22, panel 3), and retail sales, industrial production and fixed-asset investment all surprised sharply on the downside last month. We expect an easing of policy, but only a moderate one. Elsewhere in Emerging Markets, central banks continue to struggle with the puzzle of whether they need to raise rates (as Russia, Brazil and Mexico have done) in the face of rising inflation and falling currencies, despite continuing underlying weakness in their economies. Interest Rates: US inflation looks stickier than believed three months ago, with a broadening of inflation away from just pandemic-affected items (see “How Worried Should We Be About Inflation?" on page 8). But inflation expectations are still well under control (Chart 22, panel 4) and so the Fed is likely to begin tapering only in December and not raise rates until end-2022. This will most likely cause a moderate rise in long-term rates with the 10-year US Treasury yield rising to 1.7% by year-end and 2-2.25% by the time of the first Fed rate hike. Inflation elsewhere in developed economies looks more subdued (except in the UK and Canada), and so long-term rates are likely to rise somewhat more slowly there.Global Equities Chart 23Watch Earning Revisions Watch Earning Revisions Watch Earning Revisions  Global equities ended the quarter more or less flat after a very strong performance in the first eight months of the year and a volatile September. Earnings growth continued its strong trend from the first half, powered by margin improvement in both the DM and EM universes. Consequently, the forward PE multiple contracted further (Chart 23).Going forward, despite worries about the potential spillover to the global economy and global financial markets from China’s Evergrande fiasco, the “earnings-driven” theme will likely continue. BCA’s global earnings model points to over 40% earnings growth for the next 12 months, and all sectors have positive forward earnings estimates. However, net revisions by analysts seem to be cresting as the global manufacturing PMI has rolled over from a very high level. Even though valuation is less stretched than at the beginning of the year, equities are still expensive by historical standards. In addition, central banks are preparing for an eventual withdrawal of their massive liquidity injections and there is still plenty of uncertainty concerning Covid variants. GAA has been cautiously optimistic so far this year with overweights on equities and cash relative to bonds, and overweight US equities relative to Japan, Europe and China. These positions have panned out well. After adjustments made in April and July, our sector portfolio has been well positioned by overweighting Industrials, Financials, Real Estate and Healthcare, underweighting Materials, Utilities and Consumer Staples, and being neutral on Tech, Consumer Discretionary and Communication Services. We have not made any changes to our sector recommendations this quarter.In accordance with our long-held belief of “taking risk where risk will likely be rewarded the most,” we make the following adjustments to our country allocations: close the underweights in China and Japan and the overweight in the UK; and initiate one new position: Underweight EM-ex-China. Overall, our country portfolio has a defensive tilt with an overweight in the US (defensive) and underweights in the euro area and EM-ex China (cyclical), while being neutral on the UK, Japan, Australia and Canada.  Country Allocation: Upgrade MSCI China And Japan, Downgrade UK And EM-ex-China. We have been underweight MSCI China and overweight the UK since April 2021, and underweight Japan since July 2019.The China underweight generated outperformance of 23% and the UK overweight -2%, while the Japanese position produced an outperformance of 7%. Chart 24Favor China vs The Rest of The EM Favor China vs The Rest of The EM Favor China vs The Rest of The EM  While the fate of Evergrande Group, China’s second largest property developer, remains uncertain, our view is that the government will come up with a restructuring plan to minimize damaging ripple effects on the Chinese economy. This view is supported by the behavior of the domestic A-share market and also the CNY/USD, which has diverged from the offshore equity market (Chart 24, Panel 5).BCA Research’s house view is that China will now stimulate its economy, but only at a measured pace. This means that further underperformance of MSCI China is likely to be limited relative to the global benchmark, as shown in Chart 24, panel 1. The ongoing deleveraging in the Chinese real estate sector, however, means that activity in the sector will probably slow further, reducing demand for construction materials. This may put a dent on the strength of metal prices, therefore negatively impacting the ex-China EM equity index, as shown in panel 2.Moreover, the relative performance of China vs non-China EM is approaching a very oversold level while the relative valuation measure is at an extreme (Chart 24, panels 3 and 4). As such, we switch our positioning by upgrading Chinese equities to neutral from underweight and downgrade EM ex China to underweight from neutral. This implies an overall underweight to Emerging Markets.We also close the UK overweight to support an upgrade in Japan (see more details on page 13). The UK overweight was largely based on a positive view of the GBP, which has now risen to fair value.Government Bonds Chart 25Watch Inflation In 2022 Watch Inflation in 2022 Watch Inflation in 2022  Maintain Below-Benchmark Duration. Global bond yields ignored the sharp rise in core inflation in Q3. The US 10-year Treasury yield actually declined in the first two months of the quarter in response to the muted inflation readings in non-Covid related segments of the economy. Even with the fast run-up in yields in September, the US 10-year yield finished the quarter at 1.52%, only about 5 bps higher than the level on June 30th (Chart 25).We have advised clients to focus on the jobs market to determine when the Fed will lift the Fed Funds Rate off its zero bound because of the Fed’s emphasis on “maximum employment” as a pre-condition for this. However, the Fed has not clearly defined what “maximum employment” means. According to calculations by our US bond strategists, the US unemployment rate will fall to 3.8%, with a 63% participation rate, by the end of 2022 if job creation averages a reasonably achievable 414,000 per month until then. Our bond strategists think that the Fed will be forced to clarify its definition of “maximum unemployment” over the coming months and, as we get close to it next year, the key indicator to watch will shift back to inflation. If inflation remains high, then the Fed will be quicker to declare that the labor market is at “maximum employment”, and vice versa.Currently, the overnight index swap curve indicates the first rate hike will be in January 2023 with a total rate increase of 123 bps by the end of 2024. BCA Research’s house view is that the Fed will announce its first hike in December 2022 and will hike at a faster pace than what is priced in by the market. This is based on our view that unemployment will likely reach 3.5% by end-2022 with inflation above the Fed’s target. This would suggest that long-term rates will rise too, and so bond investors should remain below benchmark duration.Corporate BondsSince the beginning of the year, investment-grade credit has provided roughly 200 basis points of excess return over duration-matched Treasurys, while high-yield bonds have generated almost 600 basis points. Chart 26Continue to Favor High-Yield Credit Continue to Favor High-Yield Credit Continue to Favor High-Yield Credit  We continue to have a neutral allocation to investment-grade credits within the fixed-income category. While supportive monetary policy should generally favor spread product, we believe there is much better value to be found outside investment-grade bonds, since these bonds are currently trading at historically high valuation levels (Chart 26, panel 1).We think valuations look much more attractive in the high-yield space, and as a result remain overweight within the fixed-income category. Our US Bond Strategy service expects the share of defaults in the space to fall to between 2.3% and 2.8% – below the default rate currently priced in by the market (Chart 26, panel 2). Within high yield, we prefer B-rated bonds since they offer the most attractive spread pickup on a risk-adjusted basis.What about EM debt? Currently we are cautious on EM corporate debt. The default of Chinese real estate developer Evergrande is likely to have ripple effects throughout EM credit markets and currencies. There are already signs of considerable strains, with EM corporate spreads starting to rise (Chart 26, panel 3).  We recommend that investors focus on EM sovereign issuers such as Mexico, Russia, and Malaysia, given that they provide a significant yield pickup over US bonds with comparable credit ratings, and are less likely to default than their corporate counterparts.CommoditiesEnergy (Overweight): Oil prices are likely to remain close to current levels for the remainder of this year. However, recovering demand – particularly from Emerging Markets – and production discipline by the OPEC 2.0 coalition should support prices over the next two years. Given this backdrop, our Commodity & Energy strategists expect the price of Brent crude to average $75 and $80 per barrel in 2022 and 2023 respectively, with WTI trading $2-$4/bbl lower. Chart 27Limited Upside For Oil And Metals In The Short-Term Limited Upside For Oil And Metals In The Short-Term Limited Upside For Oil And Metals In The Short-Term  Industrial Metals (Neutral): Industrial metals’ prices have bifurcated. Those relating to alternative energy, such as copper, nickel and cobalt, continue to rise and are up 30% on average since the beginning of the year. Iron ore on the other hand has taken a colossal hit, falling over 53% from its May high. The knock-on effects of accelerating Chinese production cuts and softening economic activity, as well as Evergrande’s debt woes, will continue to put downward pressure on prices. In the short-term, we do not expect a significant rebound. However, in the longer-term, demand will recover – particularly if China implements significant stimulus – and supply will remain tight, which will help metal prices to recover.Precious Metals (Neutral): Gold prices did not react positively to the decline in US real rates over the past quarter. In fact, gold prices are slightly down, by ~1.5% since the start of July (Chart 27, panel 4). We expect real rates to rise as economic growth and the labor market recover and the Fed turns slightly more hawkish, while inflation moderates as base and pandemic effects abate. Rising real rates are a negative factor for the gold price. Nevertheless, inflation is likely to be a bit stickier than the market is currently pricing in, and we therefore maintain a neutral exposure to gold, since it is a good inflation hedge.CurrenciesUS Dollar Chart 28Do Not Underweight The Dollar Yet Do Not Underweight The Dollar Yet Do Not Underweight The Dollar Yet  Since we went from underweight to neutral on the dollar in April, the DXY has risen by only 1%. Our position remains the same for this quarter. On the one hand, momentum – one of the most reliable indicators for cyclical movements in the dollar – has turned firmly positive. Moreover, pain in the Chinese real-estate sector should weight on commodities and emerging markets – a development which historically has been bullish for the USD (Chart 28, panel 1). However, not all is good news for the greenback. Relative growth and inflation trends are starting to rebound in the rest of the world vis-à-vis the US (Chart 28, panel 2). Additionally, speculators are now firmly overweight the USD, and it remains expensive by 11% relative to PPP fair value. We believe that these forces could eventually be strong enough for the dollar bear market to resume. As a result, we are putting the US dollar on downgrade watch. Canadian DollarWe believe that there is upside to the Canadian dollar. Canada’s employment market is recovering faster than in the US, which should prompt the BoC to normalize interest rates before the Fed. Additionally, while many commodities are likely to suffer as China’s real estate market slows, oil should hold up relatively well since its demand is not as dependent on the Chinese economy. As a result, we are upgrading the CAD from neutral to overweight. Australian DollarWe remain underweight the AUD. While it is true that the AUD is now cheap on a PPP basis, weakness in iron ore from a slowing Chinese real-estate market should continue to weigh on the Aussie dollar. Chinese YuanWe are negative on the yuan on a cyclical basis. Interest-rate differentials should start moving against this currency (Chart 28, panel 3). While the Fed is likely to tighten policy as the labor market enters full employment, Chinese authorities will ease monetary policy to avert a full-blown crisis in their real-estate market.Alternatives Chart 29Outlook Remains Favorable For Private Equity And Real Estate Quarterly Portfolio Outlook: Stay Bullish But Verify Quarterly Portfolio Outlook: Stay Bullish But Verify  Return Enhancers: With public markets expensive and unlikely to provide investors with more than single-digit returns, the focus has shifted to alternative assets, particularly private equity (PE). Performance continues to be impressive, with an annualized return of 59% in Q4 2020 (Chart 29, panel 1). This supports our previous research that funds raised during recessions and early in expansions tend to outperform those raised late-cycle. Distributions from existing positions should allow limited partners (LPs – the investors who provide capital to PE funds) to commit to newer funds. Data from Preqin shows that more than $610 billion has been raised so far during 2021 (Chart 29, panel 2). We continue to favor Private Equity over Hedge Funds.Inflation Hedges: Last year’s inflationary pressures should moderate over the coming months as base effects and supply chain bottlenecks abate. Given this backdrop, we maintain our positive view on real estate versus commodity futures. Commodity prices have already shot up over the past 18 months and have limited upside from current levels: Energy prices are up by 61% since the beginning of the year, industrial metals 24%, and agriculture 17%. Over the past 15 years, REITs outperformed commodity futures when inflation was between 0% and 3% (Chart 29, panel 3). There are opportunities within the real-estate sector, despite our concerns about weaknesses in some segments of commercial real estate such as prime office property in major cities.Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress. MBS spreads, on the other hand, while wider than the pre-pandemic level, remain tight compared to the pace of mortgage refinancing (Chart 29, panel 4).Risks To Our ViewOur main scenario is based on a Goldilocks-like view of the world: That growth will be robust, but not so strong as to push up inflation further and cause central banks to turn hawkish. The risks, therefore, are that the environment turns out to be either too hot or too cold. Chart 30A Resurgence Of Covid A Resurgence Of Covid A Resurgence Of Covid  What could cause growth to slow? Covid remains the biggest risk. Cases are still high in many countries, and could rise again as people socialize indoors during the colder months (Chart 30). A more virulent strain is not inconceivable. Governments will be reluctant to impose lockdowns again, but consumers might become wary about going out.We have written elsewhere (see page 11) about the risks coming from a China slowdown and the aftermath of the Evergrande affair. A policy mistake is not improbable: The Chinese authorities want to stimulate the economy, but at the same time keep a lid on property prices. That will be a hard balance to achieve. Slower Chinese growth would hurt commodity producers and many Emerging Markets. Other risks to growth include fiscal tightening as employment-support schemes end and countries look to repair their budget positions (Chart 31), consumers building up precautionary savings and not spending their excess cash (see page 9), and problems caused by rising energy prices.Our view remains that the currently high inflation is transitory. But it is proving quite sticky and could remain high for a while. Inflation expectations are well anchored for the moment (Chart 32) but could rise above central banks’ comfort-zones if recorded core inflation in the US, for example, currently 3.6%, stays above 3% for another 12 months. This could bring forward the date of the first Fed rate hike (currently priced in for January 2023), raise long-term rates and, in turn, push up the dollar. A combination of rising US rates and a stronger dollar would have very negative consequences for heavily indebted Emerging Market economies. Chart 31Fiscal Drag Fiscal Drag Fiscal Drag   Chart 32Deanchoring Of Inflation Expectations Deanchoring Of Inflation Expectations Deanchoring Of Inflation Expectations   Footnotes1 Please see China Investment Strategy Report "The Evergrande Saga Continues," dated September 29, 2021 and Emerging Markets Strategy Report "On Chinese Internet Stocks, Real Estate And Overall EM," dated September 16, 2021,  available at https://www.bcaresearch.com/GAA Asset Allocation

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

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

Dear client, There will be no weekly bulletin next week. Instead, I will be hosting a webcast, with my colleague, Matt Gertken, titled “Currencies And Geopolitics: A Discussion.” I hope you will tune in so that we can have an interactive session. Also, we will be revamping the traditional backsections that FX has been publishing and will send a mockup in the coming weeks. Feedback on the new format will be greatly appreciated. Finally, I hosted a webcast this week with Japanese clients titled “A Guide To Currency Management For Japanese Corporates.” For those who are interested but were unable to attend, I encourage you to consult your sales representative for a replay. Kind regards, Chester Highlights The Fed will taper asset purchases this year, but it could be a non-event for the US dollar. The reason is that the Fed is lagging other G10 central banks in tapering asset purchases. Many will end QE even before the Fed begins tapering. The two big exceptions are the ECB and the BoJ. But while dovish monetary policy is well priced into both the interest rate curve and their currencies, upside surprises are not. Most global central banks will remain data dependent. So the key to gauging the move in currencies is to observe (and forecast) economic data. On that front, the current evidence is that US growth is robust, but is losing momentum to other developed markets. Volatility in currencies will be on the rise. We went long CHF/NZD on this basis last week and maintain long yen positions. But our bias is that any rally in the DXY will fizzle out at the 94-95 level. Feature This week was a busy one for central bankers. We kicked off with the Riksbank on Tuesday, the Bank of Japan and the Federal Reserve on Wednesday, and concluded with the Swiss National Bank, the Bank of England, and the Norges bank on Thursday. The highlight was the Fed, but the general message from most central banks is that less monetary accommodation will be forthcoming, as economic activity picks up. Most central bankers also admitted that inflation was proving a bit more sticky than initially anticipated. The key question therefore for currency strategists is whether the Federal Reserve will be more or less orthodox with monetary policy, compared to other developed market central banks, and what that means for the dollar. Our bias is that while the Fed was slightly more hawkish this week, it will continue to lag other G10 central banks in curtailing monetary accommodation. The Message From The FOMC Chart I-1The Market Has Priced Fed Hawkishness The Market Has Priced Fed Hawkishness The Market Has Priced Fed Hawkishness The key development from the Fed meeting this week was an upgrade to the dot plot. Half of the committee now expects at least one interest rate hike in 2022, with perhaps 7-8 hikes by the end of 2024. This is a more aggressive path of interest rate increases compared to the June FOMC meeting. The Fed also suggested tapering could begin at the next policy meeting and end towards the middle of next year, in time for rate increases. The immediate market response to the FOMC meeting did certainly suggest a hawkish undertone. The two-year US Treasury yield rose by 4 bps, which boosted the DXY index from a low of 93 to a high of 93.5 (intraday). Stocks rose and the 10-year Treasury yield edged mildly lower. The 30/2-year Treasury slope flattened by almost 10 bps. In our view, this was a rather muted response. For one, most of these moves are fading as we go to press. More importantly, going into the meeting, the market was already priced for a liftoff in 2022. This will suggest that the market was well positioned for Fed tapering at a minimum, and possibly an upgrade to the dots (Chart I-1). The Message From Other Central Banks While the Fed is still considering tapering asset purchases (and would very likely do so) by year-end, other central banks are well ahead in exiting emergency monetary settings. Just this week: The Norges bank hiked interest rates by 25 bps. We are particularly bullish on the krone, as highlighted in our Norwegian Method report; The Riskbank will end asset purchases this year. Its balance sheet is slated to be flat for 2022. It also closed all lending facilities launched during the pandemic. The offer for USD loans via the Fed’s swap facility will expire this month; The Bank of England kept monetary policy unchanged, but has already purchased £852bn of its £895bn target for government and corporate bonds. In fact, two of its members voted this week to reduce this target by £35bn, which would have effectively ended QE on a majority vote; The Swiss National Bank said in its introductory statement that it is fighting against an expensive franc, but modestly upgraded its inflation forecasts for 2022; The sole dovish central bank (aside from the SNB) was the Bank of Japan, but with elections on the horizon, and the possibility (or not) of a big fiscal package, their policy stance made sense.  Chart I-2Central Bank Holdings Of Government Bonds Central Bank Holdings Of Government Bonds Central Bank Holdings Of Government Bonds Elsewhere, the Bank of Canada has already cut its asset purchases in half, the Reserve Bank of New Zealand has ended QE, and the Reserve Bank of Australia has already been tapering asset purchases. In a nutshell, a Fed tapering at this point is well behind the actions of other G10 central banks. This is one key reason why the DXY index has failed to punch above the 94-95 level, and is relapsing as we go to press. From a bird’s eye view, many G10 central banks already have bloated balance sheets and a strong incentive to curtail asset purchases as growth recovers. Within the G10, the US central bank has the smallest holdings of outstanding bonds (Chart I-2). This not only means that, ceteris paribus, the incentive to taper asset purchases is bigger for other central banks, but the scope for the Federal Reserve to ease monetary policy is quite substantial should another shock occur. This might explain why there is unease among other central bankers, to exit emergency settings. Admittedly, this week, traditionally dovish central banks such as the Bank of Japan and the Swiss National Bank kept policy on hold and telegraphed a message that they will keep doing so for the foreseeable future. With a slightly more hawkish Federal Reserve, this should be a negative for these currencies. The same will apply to the ECB (Chart I-3). However, it is important to note that relatively dovish policy settings are well priced into both interest rate curves and their currencies, while upside surprises are not. The market does not expect any interest rate increases in the euro area or Japan before 2024, while it is priced for an aggressive pace of Fed rate hikes (Chart I-4). The starting point for any currency investor is an extremely dovish ECB and BoJ, relative to the Fed. Chart I-3A Pickup In US Yields Has Boosted The Dollar A Pickup In US Yields Has Boosted The Dollar A Pickup In US Yields Has Boosted The Dollar Chart I-4Markets Expect A More Aggressive Fed Markets Expect A More Aggressive Fed Markets Expect A More Aggressive Fed What Could Change? Global central banks are clearly focused on two goals – the outlook for growth and what that means for their maximum employment objective, and the long-run rate of inflation. These two objectives are interlinked. On the growth front, central bankers are justifiably admitting that the outlook remains clouded due to the Delta variant of COVID-19 and supply disruptions that are muddling the manufacturing outlook. However, it is important to remember that this is a global phenomenon. On a relative basis, there has been a growth rotation from the US to other economies that has historically supported the performance of DM currencies (Chart I-5). The primary reason is that many economies outside the US were in various forms of a lockdown over the last several months. As these economies reopen, so will economic activity. Chart I-5ARelative Growth And Currencies Relative Growth And Currencies Relative Growth And Currencies Chart I-5BRelative Growth And Currencies Relative Growth And Currencies Relative Growth And Currencies On the inflation front, the most acute problem has been tied to supply bottlenecks and this is not a US-centric problem. Inflation in the euro area, Sweden, the UK, Canada, or New Zealand are all above central bank targets (Table I-1). While all these central banks view the current overshoot as temporary, most have already pared back emergency monetary settings, as we highlighted above. Table I-1Inflation In The G10 A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar The key takeaway is that most central banks view inflation risks as symmetric, while the Fed has telegraphed it is willing to tolerate an inflation overshoot following downturns (Chart I-6). During the Fed’s last two meetings, it has been clear that there is a limit to how much of an overshoot they will tolerate. However, it still suggests that the Fed remains well behind the inflation curve, with one of the most negative 2-year rates in the G10 (Chart I-7). Chart I-6The Fed And Inflation Overshoots A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Chart I-7Real Yields In The US Are Very Low A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar In a nutshell, if our bias turns out to be correct that growth does recover more earnestly outside the US, and other central banks remain more orthodox than the Fed, this will be a headwind for a stronger US dollar. A Final Note On Canada Canada re-elected a Liberal minority government on September 20. Prime Minister Justin Trudeau’s bet on a majority government, given an astute handling of the pandemic, and massive fiscal stimulus, failed. The implication is a continuation of the status quo in Canada. The good news is that the status quo is actually bullish for the loonie. As we highlighted in our recent report, minority governments tend to be positive for the loonie, while majority governments generally nudge the CAD lower post election (Chart I-8). The rationale is that fiscal policy is slated to stay easy, but not overly so, providing gentle room for the BoC to hike interest rates. Easy fiscal but tighter monetary policy is usually bullish for a currency. Chart I-8Historically, The CAD Likes A Minority Government Historically, The CAD Likes A Minority Government Historically, The CAD Likes A Minority Government Given our view on the US dollar, we expect the CAD/USD to punch above the recent 82-cent high, towards 85 and eventually 90 cents. While this view might take time to play out, both rising relative interest rates in Canada (our base case) and high oil prices will be the key catalysts. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Strategtic View A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Closed Trades