Global

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

Dear Client, I will be holding a webcast next Friday, September 24th at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT) with BCA Research’s Chief Emerging Markets Strategist Arthur Budaghyan where we will debate the outlook for EM stocks. As this week’s report conveys, I am bullish, while Arthur is in the bearish camp. Please join us for what is sure to be a fiery debate. Also, instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the stability of the American political system. I hope you will find it insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2021 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, October 7th. Best regards, Peter Berezin Chief Global Strategist Highlights After lagging the global indices, EM stocks are set to outperform during the remainder of this year and into 2022. Go long the EM FTSE index versus the global benchmark (ETF proxy: VWO versus VT). Five factors will support EM assets over the coming months: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. 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. Investors wanting to gain exposure to Chinese tech while still limiting risk should consider writing cash-covered puts. For example, a strategy of selling puts on Alibaba could generate a 9% annualized yield while giving investors access to the stock at a forward PE ratio of only 12.5. Go long an equally-weighted basket consisting of the Russian ruble and Brazilian real against the US dollar. Both currencies enjoy favorable interest rate differentials and will benefit from continued strength in commodity markets. Debating The EM Outlook BCA Research has some of the brightest, most creative strategists in the world. While we often agree on many issues, we sometimes disagree. The near-term outlook for emerging markets is a case in point. My colleague, Chief EM Strategist Arthur Budaghyan, is bearish on emerging markets over a 3-to-6 month horizon. In contrast, I am bullish. In this note, I explain why. I see five reasons why EM assets will do very well during the remainder of the year and into 2022: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Let’s examine all five reasons in turn. Vaccine Access In Emerging Markets Is Improving The proportion of EM populations which have been vaccinated is rising rapidly (Chart 1). India is now vaccinating 10 million people per day, a number that would have seemed unimaginable just a few months ago. Chart 1EM Vaccination Rates Have Been Ramping Up Rapidly The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Globally, about 10 billion doses of vaccine will be produced this year (Chart 2). This does not include potential new mRNA vaccines that China is developing. China-based Walvax Biotechnology is conducting late-stage trials in Nepal, with mass production of the vaccine expected to start in October. Sinopharm is also working on its own mRNA vaccine. Meanwhile, the number of new Covid cases in most EM economies has peaked, permitting a relaxation of lockdown measures (Chart 3). Goldman’s Effective Lockdown Index for China has eased significantly since mid-August, although this week’s outbreak in Fujian province could partially reverse that trend. Chart 2At Least 10 Billion Doses Of Vaccine Will Be Produced This Year The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 3EM Lockdown Measures Have Eased As The Number Of New Cases Has Peaked The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies It is true, as Arthur has pointed out, that vaccine hesitancy is a problem in some emerging markets. However, this may not be as significant an issue as previously believed. The huge spike in cases in highly vaccinated countries such as Israel and the UK shows that herd immunity is a pipe dream. Given this reality, as long as everyone who wants a vaccine is able to receive it, the political pressure to maintain lockdowns will dissipate. Pandemic-Induced Spike In Inflation Is Fading As in most developed economies, many emerging markets have experienced a post-pandemic rise in inflation (Chart 4). Whereas DM central banks generally looked through the inflation spike, many EMs did not have that luxury. Chart 4Inflation Across The EM Universe The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies   Worried about an unmooring of inflation expectations and currency depreciation, central banks in such countries as Brazil, Mexico, Chile, Colombia, Peru, Russia, and Turkey have all raised rates this year. Higher rates have weighed on EM growth and financial markets. The good news is that inflationary pressures are starting to abate. This week’s US CPI report for August showed an absolute decline in prices in pandemic-related categories such as airfares, hotels, admissions, and vehicles (Chart 5). Things are even improving on the semiconductor front. Chart 6 shows that memory chip prices are in a clear downtrend. Chart 5Pandemic-Driven Inflation Is Cresting The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 6Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chart 7Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Critically for emerging markets, agricultural prices have stabilized (Chart 7). Historically, food inflation has been a major driver of EM inflation. Chinese Stimulus On The Way Growth in China was quite weak in the first half of the year, averaging only 3.5% on a sequential annualized basis (Chart 8). The Bloomberg consensus estimate is for Q3 growth to hit 4.3%, reflecting the negative impact of lockdown measures and the lagged effect from policy tightening. Growth in the fourth quarter is expected to rebound to only 5.7%. This seems too low to us. Barring a major spike in Covid cases, Chinese industry will be saddled with fewer social distancing restrictions in the fourth quarter. Policy is also turning more stimulative. 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 9). Chart 8Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chart 9Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way   With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. On the contrary, the PBOC’s meeting with financial institutions on August 23rd revealed a desire to increase credit availability. Partly reflecting this development, new bank loans rose to RMB 1.22 trillion in August, up from RMB 1.08 trillion in the prior month. Chart 10EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed On the fiscal side, the Ministry of Finance stated on August 27th 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. To reinforce the need for more stimulus, the authorities announced an additional RMB 300 billion in credit support for SMEs during the latest State Council meeting held on September 1st. Local Chinese government spending has typically flowed into infrastructure. Increased infrastructure spending should buttress metals prices while providing a tailwind for global industrial stocks. I agree with Arthur’s assessment that industrials will be a winning equity sector over the coming years. EM stocks have usually beaten the global benchmark during periods when global industrial stocks were outperforming (Chart 10).   A Weaker US Dollar Will Benefit Emerging Markets EM stocks tend to perform best when the US dollar is on the back foot (Chart 11). We expect the greenback to weaken over the next 12 months. As a countercyclical currency, the dollar is likely to struggle in an environment of above-trend global growth (Chart 12). Chart 11EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening Chart 12The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Interest rate differentials have moved sharply against the dollar (Chart 13). The US trade deficit has surged over the past 16 months. The way the US has been financing its trade deficit – relying heavily on fickle equity inflows – also leaves the dollar in a vulnerable position (Chart 14). Chart 13Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Chart 14Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Go Long BRL And RUB Against a backdrop of broad-based dollar weakness, EM currencies will strengthen. Currently, the 12-month interest rate differential between Brazil and the US stands at 8.7%, up from a low of 2.1% last year. Russian rates have also risen rapidly relative to US rates (Chart 15). The Russian ruble will benefit from the cyclical recovery in oil prices. Bob Ryan and BCA’s commodity team project that the price of Brent will rise 5% to $80/bbl in 2023, whereas market expectations are for a 12% decline (Chart 16). Likewise, Brazil will gain from both higher oil prices and rising Chinese demand for metals. Chart 15Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Chart 16Oil Prices Have More Upside Oil Prices Have More Upside Oil Prices Have More Upside Accordingly, we are initiating a new trade going long an equally-weighted basket consisting of BRL/USD and RUB/USD. Are EMs A Value Trap? Emerging market stocks currently trade at a Shiller PE ratio of 14.7, compared to 36.8 for the US, 22.2 for Europe, and 24.1 for Japan. The EM discount to the global index is as large now as it was during the late 1990s. Other valuation measures tell a similar story (Chart 17). Chart 17AEM Equities Are Trading At A Large Discount (I) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 17BEM Equities Are Trading At A Large Discount (II) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies A low PE ratio for EM stocks could be justified based on weak expected earnings growth. However, it is far from clear that such an expectation is warranted. While EM earnings growth has lagged the US since 2011, this follows a decade when EM earnings grew much faster than in the US (Chart 18). Chart 18AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) Chart 18BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) Chart 19EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings On that note, it is worth mentioning that US earnings have risen by only 6 percentage points more than EM earnings since mid 2019 (20% versus 14%), even as EM stocks have underperformed their US peers by 29% over this period (52% versus 23%) (Chart 19). China’s Regulatory Crackdown The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 48% since February (Chart 20). Chart 20Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers 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 just as US companies have pledged allegiance to woke ideology. 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 16.4-times earnings, Baidu is trading at 17.9-times earnings, and Tencent is trading at 26.7-times current year earnings. In comparison, the NASDAQ 100 trades at nearly 30-times earnings. Investment Conclusions Sentiment towards EM stocks is very bearish (Chart 21). Investor angst towards China is especially elevated, with the media replete with stories about the tech crackdown and problems at Evergrande, the country’s largest property developer. Chart 21Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish All these downside risks to EM assets are well known. What are less well known are the upside risks stemming from higher vaccination rates, an easing of domestic inflationary pressures, Chinese stimulus, a weaker US dollar, and favorable valuations. With that in mind, we are upgrading our rating on EM equities and currencies to strong overweight in the view matrix at the back of this report. We are also reinstating a long EM/Global equity trade (ETF proxy: VWO versus VT). The risk-reward of buying Chinese internet stocks is reasonably appealing. Investors who want to mitigate risk should consider writing cash-covered puts. For example, a BABA put with a strike price of $130 expiring on December 16th 2022 trades for about $16. If the price of BABA does not fall below $130, you will pocket the premium, realizing an annualized yield of 9%. If the price does fall to $130, you get the stock at an attractive PE ratio of 12.5 based on current forward earnings estimates.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Special Trade Recommendations The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Current MacroQuant Model Scores The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies