Inflation/Deflation

Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of.  Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows.    President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress.  We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown.     Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures.  Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers Inflation Rattles Policymakers Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans.  Chart 2Higher Wages: Real Or Nominal? Higher Wages: Real Or Nominal? Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction.      Chart 3Policymakers Fear Populism, Focus On Employment Policymakers Fear Populism, Focus On Employment Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage.   Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). Chart 4 However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. Chart 5 The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable.   There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran.      Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Energy Price Depends On Winter ... And Russia/Iran! Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war.    Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Chart 7 Chart 8 Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later.   Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly.  After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz.  Chart 9Now Iran Can Use 'Maximum Pressure' Now Iran Can Use 'Maximum Pressure' Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China.  The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad.  The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated.  Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. Chart 10 What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector.  Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets.    China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary:    Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed.  Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 11 Chart 12China Has Not Contained Property Turmoil China Has Not Contained Property Turmoil China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening.   China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening China Tries To Avoid Over-Tightening China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt China Slowdown Not Yet Fully Felt China Slowdown Not Yet Fully Felt ​​​​​​​Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation.    It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally.     Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship.   The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). Chart 15 Chart 15 The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Chart 16 Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks.   Chart 17 Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com       Footnotes 1     Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2     Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3    Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012).  4    See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org.  5    Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions  Image

Highlights So far, both the demand and supply side of the Philippine economy have been rather weak; yet there are signs that growth is set to revive. Fiscal expenditures have bottomed. Bank lending is also reviving. Acceleration in broad money supply is usually a good omen for stronger economic activity (Chart 1). Being a defensive market within EM, Philippine stocks will benefit in an impending period of weak EM stock prices. Upgrade this bourse from underweight to neutral in an EM equity portfolio. Philippine sovereign credit is also defensive in nature relative to its EM peers. Stay overweight in an EM portfolio. A deteriorating external accounts outlook makes the peso vulnerable. The central bank will also likely tolerate a weaker currency. Stay short the peso versus the US dollar. A vulnerable peso renders Philippine domestic bonds unappealing. Stay neutral in an EM domestic bonds portfolio. Feature The steep underperformance of Philippine stocks over the past several years is due for a pause. While this bourse may not see a sustainable rally in absolute terms, a period of flattish relative performance vis-à-vis the EM benchmark is likely. We recommend upgrading this market from underweight to neutral within an EM equity portfolio (Chart 2). Chart 1Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Chart 2Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms One reason why Philippine stocks are unlikely to rally in absolute US dollar terms is a vulnerable peso. Philippine external accounts will likely deteriorate further, and therefore the peso is set to continue to trade on the weaker side. Currency investors should stick with our recommended short the peso versus US dollar trade for now. Philippine domestic bonds also remain unattractive to foreign investors. Local bond yields are not high enough relative to those of safe-haven bonds (US treasuries). As a result, the country is witnessing net debt portfolio outflows. The nation’s sovereign USD bonds, however, will likely outperform the EM benchmark going forward and merit an overweight stance in an EM sovereign bond portfolio. A Feeble Economy …   The Philippine economy, so far, continues to be soft. Demand has been sluggish: manufacturing sales remain well below pre-pandemic levels – both in value and volume terms. So are car sales (Chart 3). On the supply side, production volume gives a similar message: they are still below pre-pandemic levels. Manufacturing PMI is barely in the expansion territory (Chart 4). In other words, there is palpable weakness in both the demand and supply side of the domestic economy. Chart 3The Demand Side Of The Economy Has Been Weak... The Demand Side Of The Economy Has Been Weak... The Demand Side Of The Economy Has Been Weak... Chart 4...So Has Been The Supply Side ...So Has Been The Supply Side ...So Has Been The Supply Side The soft domestic demand is also evident from the import cargo throughput in the country’s ports. While exports cargo has risen well above pre-pandemic levels, import cargo has not (Chart 5). Part of the reason behind the lingering frailty is muted fiscal spending. Over the past 12 months, the latter has decelerated measurably. To be sure, Philippine fiscal outlays during the entire pandemic period have not been extraordinary; and yet this has slowed further (Chart 6, top panel). Chart 5Weak Domestic Demand Is Also Evident In Still Subdued Imports Weak Domestic Demand Is Also Evident In Still Subdued Imports Weak Domestic Demand Is Also Evident In Still Subdued Imports Chart 6Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent   The sharp widening seen in the country’s fiscal deficits had more to do with dwindling fiscal revenues, rather than strong spending. In fact, central bank data shows that most of its government bond purchase proceeds (‘QE’ proceeds) are unspent – still sitting in the government’s accounts with the central bank, i.e., they have not been channeled into the economy (Chart 6, bottom panel). … But Plenty Of Dry Powder Going forward, however, that picture is likely to change. The country is heading into general elections in May 2022. Lawmakers therefore have an incentive to spend the amount currently lying in the central bank. The amelioration in the number of new Covid-19 cases has enabled a re-opening of the economy, which will make stimulus spending easier. In addition, the federal budget for 2022 passed last month1 includes an 11.5% hike in government outlays. With core CPI at 3%, this translates into a robust 8.5% government expenditure growth rate in real terms. Chart 7Credit Is Finally Reviving Credit Is Finally Reviving Credit Is Finally Reviving Beyond fiscal spending, the country’s bank credit might also gain some traction: During the pandemic, banks shunned loan disbursements. Lately, however, there are signs that credit is reviving (Chart 7). Real borrowing costs (prime lending rates deflated by core CPI) from banks are low, close to only 1%. Such low cost of credit should encourage new borrowing at a time when economic activity is resuming. On their part, banks have made sizeable provisions against the rising NPLs during the pandemic, and therefore have already taken a substantial hit on their books (Chart 8, top panel). Relatively cleaner balance sheets should encourage banks to lend. Banks have also been able to materially raise their operating efficiency in the past couple of years (by way of rising net interest income). As a result, operating margins have improved measurably. This has helped absorb part of the NPL-related losses and has somewhat cushioned the blow to banks’ bottom line (Chart 8, bottom panel). Relatively better margins (than otherwise would have been the case) should prompt banks to take relatively higher risks, i.e., expand their loan books going forward. Should fiscal authorities ramp up their spending, and should banks also begin to lend again, the activity that has resumed following a lessening of Covid-19 cases will get a fillip. Higher fiscal spending and bank credit will lift money supply in the economy, usually a good omen for stronger economic activity (see Chart 1 on page 1). Incidentally, inflation in the Philippines is under control. The relatively high headline inflation print is not indicative of any genuine inflationary pressures, and is due mostly to food prices, which account for 38% of the CPI basket. Core and trimmed mean CPI are much lower at around 3% (Chart 9, top panel). Chart 8Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Chart 9There Are No Genuine Inflationary Pressures In The Philippines There Are No Genuine Inflationary Pressures In The Philippines There Are No Genuine Inflationary Pressures In The Philippines The central bank expects the headline inflation rate to decelerate to within its target band of 2% to 4% by the end of this year and settle close to the midpoint in 2022 and 2023. At the same time, Philippine nominal wages are barely growing (Chart 9, bottom panel). This implies that businesses have little margin pressures to raise their selling prices. Genuine inflationary pressures, therefore, are unlikely to become acute in the foreseeable future. That, in turn, will help keep fiscal and monetary policies accommodative.  Domestic Bond Yields Will Stay Flattish With the resumption of economic activity, will come higher fiscal revenues. That should help the Philippine fiscal deficit to narrow.  Narrower fiscal deficit in the Philippines is usually bond bullish (i.e., bond yields go down). Yet, lower bond yields will have negative implications for Philippine capital inflows. Foreign investors are the marginal buyers of Philippine bonds. And their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds (US treasuries). Chart 10 shows that whenever the yield differential narrows too much (to around 200 basis points), net debt portfolio inflows into the Philippines typically stop, and often turn into outflows. This is what is happening now. On the other end, when the differential widens enough (about 400 - 500 basis points), those outflows turn into inflows again. Chart 10The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows Given that we expect US long-term bond yields to rise, if Philippine bond yields do not rise at an even faster pace, its yield differential would stay low. Thus, the country will be hard-pressed to see any debt portfolio inflows in the near future. The absence of foreign buyers, in turn, would put a floor under bond yields. This will counterbalance any yield-suppressing forces coming from improving fiscal deficits. Thus, overall, the country will likely see flattish yields over the next six to nine months. And The Peso, Shaky Chart 11Debt Dominates The Philippines' Capital Inflows Debt Dominates The Philippines' Capital Inflows Debt Dominates The Philippines' Capital Inflows Low bond yields and short-term interest rates will have negative ramifications for the currency: It’s the foreign debt flows, rather than equity investments, that dominate Philippine capital inflows. This is true for all categories of inflows: FDI, portfolio and other investments (Chart 11). The fact that debt investors are the dominant group among foreign investors has some implications. Debt investors do not like lower interest rates while equity investors do. As such, debt inflows into the Philippines diminish when the interest rates (bond yields) are relatively low. Muted foreign capital inflows, in turn, are bearish for the peso. The country’s current account outlook is also not rosy. The trade deficit has widened significantly, and the robust current account surplus has given way to deficits – in line with our forecast in our previous report. With domestic demand reviving (government spending, household consumption and business investment), imports will now likely grow faster than exports, and therefore, will weigh down on both trade and current account deficits further in the months ahead. Notably, the country’s overseas workers’ remittances have also rolled over in recent months. All these will be a headwind for the peso (Chart 12). As noted, the central bank does not expect inflation to overshoot their target in the next two years. They have also been a net buyer of US dollars year-to-date, i.e., they have been leaning against their currency. This implies that they would not mind a weaker currency – especially when the economy is still not strong, and inflation is not a threat. Incidentally, the peso is also about 7% expensive vis-à-vis the US dollar in purchasing power terms (Chart 13). Chart 12Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Chart 13The Peso Is Somewhat Expensive In PPP Terms And Is Vulnerable To A Downside The Peso Is Somewhat Expensive In PPP terms And Is Vulnerable To A Downside The Peso Is Somewhat Expensive In PPP terms And Is Vulnerable To A Downside Equity Underperformance Is Late An improving fiscal balance is usually bullish news for Philippine stock multiples. The connection is via bond yields/interest rates. An improving fiscal balance leads to lower bond yields, which, in turn, boost this market which is dominated by interest rate sensitive sectors (real estate, financials/banks and utilities make up 50% of market cap). Chart 14Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Yet, in this cycle, an improving fiscal balance may not herald a material fall in the country’s bond yields due to net debt portfolio outflows (as explained above). Thus, Philippine stocks would miss the tailwind from rising multiples. A dim outlook for the peso also calls for caution on the part of absolute-return foreign investors. That said, the resumption of economic activity will lead to rising earnings, and that should provide some tailwinds for this market. Moreover, as a defensive market within EM, Philippine stocks usually outperform the overall EM benchmark during periods of weak EM stock prices. Incidentally, we have a negative outlook on EM stock prices over the coming several months (Chart 14). Weighing all the pros and cons, we infer that Philippine stocks’ relative performance will likely be rangebound over the next six to nine months. Sovereign Credit Will Outperform Chart 15The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight A negative outlook on overall EM sovereign credit warrants overweighting Philippine sovereign credit relative to its EM brethren. The reason is the defensive nature of the Philippine sovereign bond market – just like its equity market. During periods of stress, Philippine sovereign spreads widen much less than its EM peers. Chart 15 shows that in each of the last three risk-off periods (2008-09, 2015, 2020), Philippine sovereign credit massively outperformed the EM benchmark. The basis for the defensive features of Philippine sovereign credit is that the nation’s external public debt is quite low at 18% of GDP, down from 25% ten years back. Of this, foreign bonds outstanding are 10% of GDP, down from 12% ten years back (the rest being loans and contingent liabilities). Such low debt means the defensive nature of this market is unlikely to change soon. Hence, it makes sense to overweight Philippine sovereign bonds in view of impending sovereign credit spreads widening in the broader EM universe. Investment Conclusions Stocks: The Philippine economy will likely see some traction in the months ahead as fiscal spending rises and bank credit revives. This bourse’s relative performance will also benefit in an impending risk-off period in emerging markets. Asset allocators should upgrade this market from underweight to neutral in an EM equity portfolio. Our underweight call on this market vis-à-vis an EM equity portfolio has yielded a gain of 16% since we recommended it in October 2018. The Peso: The peso remains vulnerable in the face of deteriorating external accounts. Currency investors should stay with our recommended long USD/ short PHP trade for now. This call has yielded 2.1% so far since our recommendation on March 18, 2021. Chart 16Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Domestic Bonds: Local currency bond yields in the Philippines are likely to stay flattish despite the slated improvements in the country’s fiscal balance. The peso is also set to stay weak. These call for a cautious stance on Philippine domestic bonds. Yet, they tend to do well relative to their EM counterparts during periods of EM stress – as they did in 2015 and in 2020 (Chart 16). Since another such period is around the corner, we recommend that investors maintain a neutral allocation of Philippine local currency bonds in an EM portfolio.    Sovereign Bonds: Philippine sovereign bonds are set to outperform their EM counterparts. Asset allocators should stay overweight the Philippines in a dedicated EM sovereign bonds portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 Passed in the third and final reading in the lower house and sent to the Senate, the upper house.

Highlights Fed/BoE: Both the Fed and the Bank of England found ways to talk down 2022 rate hike expectations discounted in US and UK bond markets. This is only a temporary reprieve, however, as the near-term uncertainties over the persistence of cost-push inflation will eventually be overwhelmed by medium-term certainties of demand-pull inflation confirmed by tightening labor markets. Stay underweight US Treasuries and UK Gilts in global bond portfolios. US Treasury Curve: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022. Feature Chart of the WeekShifting Rate Expectations Driving Bond Yields As QE Fades Shifting Rate Expectations Driving Bond Yields As QE Fades Shifting Rate Expectations Driving Bond Yields As QE Fades Bond market uncertainty about future monetary policy moves is on the rise. Bond volatility has picked up, most notably at the front end of yield curves that are most sensitive to rate hike expectations which have been intensifying. Yet last week, the Federal Reserve and Bank of England (BoE) were able to talk bond investors off the ledge – at least, temporarily - by pushing back against expectations of multiple rate hikes in the US and UK in 2022. Central bankers in those countries are stuck in a difficult spot. Inflation is high enough to warrant some tightening of monetary policy. Yet there are lingering concerns over how long the current upturn in global inflation will last. Meanwhile, there are just enough questions on the underlying pace of economic momentum to require policymakers to see more data, especially in labor markets, before feeling comfortable enough to pull the trigger on actual rate hikes. We now see that happening first in the UK early next year, and in the US in late 2022. One thing that is certain is that the ups and downs of interest rate expectations – and the central bank forward guidance that influences them – will increasingly become the more dominant driver of bond yields and yield curve shape as global pandemic bond-buying programs get wound down (Chart of the Week). On that front, we see more potential for bond-bearish steepening in the UK and US over the next several months. The BoE: Another Bad Date With The Unreliable Boyfriend The UK financial press infamously dubbed the BoE “the unreliable boyfriend”, under the leadership of former Governor Mark Carney, for hinting at interest rate increases that never materialized. At last week’s Monetary Policy Committee (MPC) meeting, rates were kept unchanged in a 7-2 vote despite some intense signaling in recent weeks that a rate hike was imminent. Under current BoE Governor Andrew Bailey, this edition of the MPC is more like an indecisive spouse than unreliable boyfriend. On the one hand, there is a clear overshoot of UK inflation (and inflation expectations) that would justify a rate hike as soon as possible (Chart 2). The BoE’s new economic forecasts presented in the November Monetary Policy Report (MPR) called for headline CPI inflation to reach a peak of 5% in April 2022 – significantly higher than the 4% late-2021 forecast from the August MPR. On the other hand, high current inflation is already having a dampening effect on economic sentiment. The GfK index of UK consumer confidence is down -10% from the peak seen in July, despite diminishing concerns over COVID seen in public opinion polls (Chart 3, middle panel). A similar divergence is evident in the BoE’s Decision Maker Panel survey of UK Chief Financial Officers, which showed that uncertainty over future sales was somewhat elevated compared to diminished concerns about COVID and Brexit (bottom panel). Chart 2Fed/BoE Cannot Stay Dovish For Much Longer Fed/BoE Cannot Stay Dovish For Much Longer Fed/BoE Cannot Stay Dovish For Much Longer Chart 3High UK Inflation Raises Growth Uncertainty High UK Inflation Raises Growth Uncertainty High UK Inflation Raises Growth Uncertainty The BoE highlighted these divergences in economic sentiment series in the November MPR as examples of how high inflation, fueled by global supply chain disruptions and soaring energy prices, introduced uncertainty into the central bank’s forecasts. Even more uncertainty exists in the BoE’s ability to assess the amount of spare capacity, and underlying inflationary pressure, in the UK economy. The BoE dedicated a 9-page section of the November MPR to a discussion about estimating the growth of the supply-side of the UK economy, evidence of how difficult that process has become during the COVID era. The BoE concluded that the pandemic would end up reducing the level of UK potential supply by -2% from pre-COVID levels, even though the growth rate would return to a pre-pandemic pace of around 1.5% by 2023-24. This is a combination that makes setting monetary policy tricky. Reduced supply indicates that the UK economy has a smaller output gap with more inflationary pressure that would require higher interest rates. Yet sluggish growth in potential supply implies that the UK equilibrium interest rate is likely still very low, thus the BoE would not have to raise rates much to get policy back to neutral. This uncertainty over the size of the output gap in the UK economy will force to BoE to focus more on the labor market as the best “real-time” measure of spare capacity. On that front, the evidence is also difficult to interpret. The UK unemployment rate fell to 4.5% over the three months to August, the last available data before the UK government’s COVID furlough schemes, which protected worker incomes hit by COVID job losses, ended on September 30. The UK Office of National Statistics estimates that there were between 900,000 and 1.4 million UK workers furloughed in late September, representing a significant source of labor supply to be absorbed when the government income assistance ends. Thus, the BoE would need to see at least a month or two of post-furlough employment reports – not just job growth, but labor force participation - to assess how quickly those workers were being reabsorbed into the UK labor market. By the BoE’s own estimates, the impact of the furlough schemes, combined with the compositional issues arising from pandemic job losses being borne more by lower-wage workers, boosted UK wage growth by 2.2% (Chart 4, bottom panel). “Underlying” wage growth, net of those effects, is 0.6%, above the pre-COVID peak, suggesting a tightening labor market before the return of furloughed workers to the labor force. In the end, we see the BoE’s November non-hike as nothing more than a delay of the inevitable. While a December hike is possible, this would represent a “double tightening” of monetary policy with the current BoE quantitative easing program set to expire at year-end. The more likely date for a rate hike is now February. This would give the MPC a few months of post-furlough labor data to assess the amount of spare capacity in UK labor markets. We expect the data to show enough underlying health in labor demand relative to supply for the BoE to conclude that accelerating wage growth represents a more sustainable form of UK inflation in 2022 than energy prices or supply-chain disruptions were in 2021, justifying a move to begin hiking rates. We continue to recommend positioning for a steeper UK Gilt curve, focused on longer-maturities where yields were too low relative to even a moderate future BoE rate hike cycle (Chart 5). We entered a new tactical butterfly spread trade last week, going long the 10-year Gilt bullet versus a duration-neutral 7-year/30-year barbell – we continue to like that trade as a way to play for eventual BoE rate hikes in the first half of 2022. Chart 4BoE Needs More Employment Data To Confirm Wage Uptrend BoE Needs More Employment Data To Confirm Wage Uptrend BoE Needs More Employment Data To Confirm Wage Uptrend Chart 5Stay In UK Long-End Gilt Curve Steepeners Stay In UK Long-End Gilt Curve Steepeners Stay In UK Long-End Gilt Curve Steepeners Bottom Line: The Bank of England is still on a path to begin rate hikes, either in December or, more likely, February of next year. Stay underweight UK Gilts. Position For A Steeper US Treasury Curve The Fed announced last week that tapering would begin right away in November, in a move that has been hinted at since the summer. The monthly pace of purchases of Treasuries and Agency MBS will decline by $10 billion and $5 billion, respectively in November and also December. The Fed declined to commit to any specific tapering amounts beyond that, although it seems likely that the same monthly pace of reduction will continue in 2022. This would take the buying of Treasuries and MBS, net of maturing debt, to zero by June of next year, clearing the first necessary hurdle before the FOMC could contemplate a hike in the funds rate. A completion of the taper by June has been hinted at in the speeches of several Fed officials in recent weeks. This is a bit faster than the expected pace of tapering seen in the most recent New York Fed Primary Dealer and Market Participant Surveys from September (Chart 6), but should not be categorized as a hawkish surprise. There were also few bond-bearish signals on future policy moves hinted at by Fed Chair Jay Powell in post post-FOMC meeting press conference. Chart 6 Chart 7Upside Risk To UST Yields From A Tightening Labor Market Upside Risk To UST Yields From A Tightening Labor Market Upside Risk To UST Yields From A Tightening Labor Market Powell did note that it was still not clear how long the current supply chain/commodity price driven surge in inflation would persist into next year. The expectation, however, was that these forces would eventually subside and allow US inflation to return back to levels much closer to the Fed’s 2% target. Given the uncertainties in the timing of that peak and decline in US inflation, the Fed has limited ability to calibrate any post-taper rate hikes by focusing solely on inflation - especially with longer-term inflation expectations still at levels consistent with the Fed’s target. The Fed will continue to look at US labor market developments to determine the timing and pace of future rate hikes. The last set of FOMC economic projections compiled for the September meeting have the US unemployment rate falling to 3.8% next year, below the median FOMC estimate of full employment at 4%, with one 25bp rate hike penciled in for 2022. We can use that as a baseline assumption on what the Fed considers to be the level of “maximum employment” that would need to be reached before rate hikes could begin. The US unemployment rate fell to 4.6% in October, thus there is still some more to go before hitting that 3.8% rate hike threshold. Yet among the FOMC members, the estimates of full employment range from 3.5%-4.5%, so the October print did knock on the door of that range (Chart 7, middle panel). With US wage growth already showing signs of breaking out – the Atlanta Fed Wage Tracker hit a 14-year high of 14% in September (bottom panel), while the Employment Cost Index rose by a record quarterly pace of 1.3% in Q3 – the Fed will likely be under a lot of pressure to begin hiking rates soon after the taper is expected to end next June. Chart 8UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes We still see December 2022 as the most likely liftoff date, although a faster decline in unemployment could move that timetable forward. The bigger issue for the US Treasury market, however, is not the timing of liftoff but how fast the pace of hikes will be afterward. On that note, future rate expectations are still far too low. For example, according to the New York Fed’s Primary Dealer Survey, the fed funds rate is expected to average only 1.7% over the next ten years (top panel), a level that has proved to be a ceiling for the 10-year Treasury yield so far in 2021. Our colleagues at BCA Research US Bond Strategy recently made the case for expecting the US Treasury curve to bearishly steepen in the coming months. In their view, longer-maturity Treasury yield forward rates were too low compared to a fair value determined by the likely path for the funds rate that assumes rate hikes start in December of next year and rise by 100bps per year to a terminal rate of 2.08% (Chart 8). Interestingly, 2-year Treasury forward rates were in line with the projections of our US Bond Strategy team’s fair value framework. We fully agree with our US Bond colleagues on the likelihood of future Treasury curve steepening. This fits with our views on many developed market countries, not just the US, where longer-maturity bond yields were pricing in too few future rate hikes relative to what was likely to occur over the next few years. Even when taking a much longer perspective, the US Treasury curve looks too flat right now. Going back to the mid-1980s, the current 2-year/10-year US Treasury curve slope of just over 100bps has never been reached (in a flattening move) in the absence of actual Fed rate hikes (Chart 9). Chart 9UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes This week, we are adding a new trade to our Tactical Overlay table to benefit from this expected move in the US yield curve, a US Treasury 2-year/10-year curve steepener (combined with a position in cash, or US 3-month treasury bills, to make the entire trade duration-neutral). We are also taking profits on our previous Tactical US curve flattening trade, which has returned 0.84% since initiation back in June. The exact securities and weightings for our new trade can be found in the Tactical Overlay Trades table below. Bottom Line: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Overlay Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, Next week I will be hosting and attending client events, both virtual and in person. Our next report, on November 24 will be a recap of my observations from the meetings with our clients. Best regards, Jing Sima China Strategist Executive Summary Chart Of The DayThe Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High     Producer price inflation in China will likely peak in the next two quarters, but inflation could remain elevated well into 2022. Chinese producers will continue to pass on inflation to domestic and foreign consumers. Core CPI is only a notch below its pre-pandemic level; rising energy and food prices, along with improved service sector consumption, will push up headline consumer prices next year. Lack of meaningful policy easing is creating an air pocket for China’s economy, with significant near-term risks for a faster-than-expected economic slowdown. We continue to prefer the CSI500 Index over the broader onshore market. In Limbo In Limbo Bottom Line: China’s business cycle has rapidly matured while inflation remains a risk. We are still underweight Chinese equities in a global portfolio. Within Chinese stocks, we continue to favor CSI500 Index which has a greater exposure to external demand. Feature Chart 1Persistently Negative Economic Surprises Persistently Negative Economic Surprises Persistently Negative Economic Surprises China’s economic conditions deteriorated in the third quarter. Chart 1 shows that the nation’s economic surprise index remains in deep contraction. However, the combination of power shortages and persistent supply-side price pressures has limited policy choices, particularly the traditional measures used to stimulate the economy. We are closely monitoring the BCA China Play Index and the relative performance of domestic infrastructure stocks versus global equities as proxies for reflation; neither is signaling a significant improvement (Chart 2). The outlook for Chinese stocks in the next 6 to 12 months remains dim. Chinese corporate profit growth has peaked, and input cost pressure on domestic producers may prove to be stickier than the market has currently priced in (Chart 3). Chart 2Reflation Proxies Are Not Signaling A Major Economic Upturn Reflation Proxies Are Not Signaling A Major Economic Upturn Reflation Proxies Are Not Signaling A Major Economic Upturn Chart 3Corporate Profit Growth Has Peaked Corporate Profit Growth Has Peaked Corporate Profit Growth Has Peaked Producer Price Inflation Remains A Near-Term Risk China’s producer price index (PPI) inflation may stay high longer than the market is expecting. Supply-side pressures and bottlenecks will abate, but perhaps not as fast as investors expect. Moreover, energy prices will likely remain elevated into 2022 and labor shortages in the urban areas will further exacerbate inflationary pressures. As discussed in a previous report, the surge in China’s manufacturing output and prices has been driven by strong US consumer demand for goods. Robust external demand this year occurred as China’s industrial sector had gone through years of capacity reduction and domestic de-carbonization efforts gained momentum.  Chart 4Expanding Mining Capacity Takes Time Expanding Mining Capacity Takes Time Expanding Mining Capacity Takes Time Capacity in the mining sector will expand in the next 6 to 12 months if the power crunch persists. However, the 2015/16 supply-side reforms significantly reduced China’s upstream industry’s capability to produce. Given the capital-intensive nature of upstream industries, expanding production output often takes a long time. Chart 4 shows the significant lag between mining’s higher product prices, which indicate rising demand and tighter supply, and improved output and investment in the sector.  The industrial sector’s capacity utilization rate remains elevated. China’s manufacturers can ramp up output more easily compared with mining enterprises. However, both manufacturing investment growth and output in volume have been falling (Chart 5). The wide gap between manufacturing input and output prices means that the profit margin among producers of manufacturing goods has been squeezed, giving them little incentive to expand business operations (Chart 6). Chart 5Manufacturing Investment Growth And Output Volume Have Been Falling Manufacturing Investment Growth And Output Volume Have Been Falling Manufacturing Investment Growth And Output Volume Have Been Falling Chart 6The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High In addition, PPI inflation may be slow to decline for the following reasons: Coal futures prices have been clobbered since mid-October in the wake of government regulatory measures to curb speculation in the domestic commodity exchange market (Chart 7). However, the plunge does not solve the supply shortage issue. Coal prices at China’s major ports have been trending sideways and remain at historic highs (Chart 8). Chart 7Regulators Have Squashed Coal Price Speculations In Commodity Exchanges... Regulators Have Squashed Coal Price Speculations In Commodity Exchanges... Regulators Have Squashed Coal Price Speculations In Commodity Exchanges... Chart 8...But Coal Prices At Ports Remain High ...But Coal Prices At Ports Remain High ...But Coal Prices At Ports Remain High   Regulators have allowed electricity producers to boost prices by as much as 20% to industrial users. We estimate that a 20% increase in electricity prices can add anywhere from half to one percentage point to PPI. The recovery in the global service sector will provide support to oil prices (Chart 9). BCA’s Commodity and Energy Strategy service expects energy prices to soften in the next 12 months, but not by as much as the markets are discounting. Our latest forecast sets Brent crude oil at an average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl) and $81/bbl in 2023 (versus market expectations of $71/bbl) (Chart 10). Chart 9Oil Prices Find Support From Recovery In Global Service Activity Oil Prices Find Support From Recovery In Global Service Activity Oil Prices Find Support From Recovery In Global Service Activity Chart 10 China’s domestic demand has weakened, particularly in the construction sector. Prices for steel rebar, iron ore and cooper have all rolled over and/or fallen sharply (Chart 11). Nonetheless, the prices remain well above pre-pandemic levels and policy-induced production cuts may limit the downside. Labor shortages in China’s urban areas have not improved. Reverse migration has increased since early last year when China imposed travel restrictions to contain domestic COVID transmission. Workers from rural areas opted to remain in their hometowns rather than return to work in urban areas. As of Q3 this year, there were still about 2 million fewer migrant workers than in the pre-COVID years, which has exacerbated an urban labor shortage that existed before the pandemic (Chart 12). Chart 11Commodity Prices In China Have Rolled Over, But Downside May Be Limited Commodity Prices In China Have Rolled Over, But Downside May Be Limited Commodity Prices In China Have Rolled Over, But Downside May Be Limited Chart 12Migrant Workers Are Slow To Return To Urban Jobs Migrant Workers Are Slow To Return To Urban Jobs Migrant Workers Are Slow To Return To Urban Jobs Bottom Line: PPI should peak in the next one to two quarters as supply bottlenecks ease and the base factor wanes. However, China’s industrial capacity and labor market remain tight. Producer inflationary pressures may sustain longer than investors expect. Passing On Costs To Consumers Chart 13Households Are Paying Higher Prices For Durable Goods And Daily Necessities Households Are Paying Higher Prices For Durable Goods And Daily Necessities Households Are Paying Higher Prices For Durable Goods And Daily Necessities The weakness in demand from Chinese households has kept consumer price inflation subdued so far this year. Nonetheless, Chinese producers have started to pass on supply-side cost pressures to consumers, both domestic and foreign. Rising raw material costs have pushed up the price of Chinese consumer durable goods, such as home appliances (Chart 13). Consumer prices for fuel have reached the highest level since the data collection started in 2016. The cost of consumer daily necessities is also climbing: households are paying more for utilities (water, electricity and fuel) compared with pre-pandemic years and prices are at 2013 highs. Escalating electricity prices will further strengthen inflationary pressures on the CPI. While residential electricity costs are strictly regulated in China and are unlikely to rise in the near future, price inflation passthroughs will be mainly via higher costs on both consumer goods and services. If the 20% increase in electricity costs among Chinese manufacturers is passed onto consumers, it could potentially push up the CPI by about 0.2 -0.4 percentage points. The cost of food and vegetables has also jumped since early October. Given the high likelihood of La Niña this winter, food inflation could further mount and potentially push the headline CPI close to the PBoC’s 3% inflation target next year. The recovery in China’s service sector has lagged due to domestic COVID flareups and subsequent lockdowns (Chart 14A and 14B). However, service CPI has recovered to above its pre-pandemic level, with strong rebounds in tourism and transportation (Chart 15). Given that China is accelerating vaccine boosters, an improvement in the domestic COVID situation next year could further support the service sector’s consumption and prices.   Chart 14AService Sector Recovery In China Has Lagged... Service Sector Recovery In China Has Lagged... Service Sector Recovery In China Has Lagged... Chart 14BService Sector Recovery In China Has Lagged... Service Sector Recovery In China Has Lagged... Service Sector Recovery In China Has Lagged... Chart 15...But Prices Have Not ...But Prices Have Not ...But Prices Have Not Chart 16Chinese Export Growth Remained Buyout Through October Chinese Export Growth Remained Buyout Through October Chinese Export Growth Remained Buyout Through October China’s exporters are passing on inflation to their foreign customers too. Newly released trade data highlights buoyant export growth through October (Chart 16). Even though goods consumption in the US will likely converge to its long-term trend next year, inventories are at multi-year lows while global industrial production growth remains well above trend (Chart 17). China’s export growth may stay strong in the next two quarters, as suggested by our regression-based modelling (Chart 18). Exporters have been charging US and global customers less than average prices (Chart 19). Robust demand for consumer and capital goods from the US and Europe should give China’s exporters sustained pricing power. Chart 17Extremely Low Inventories In The US Will Benefit Chinese Exports Extremely Low Inventories In The US Will Benefit Chinese Exports Extremely Low Inventories In The US Will Benefit Chinese Exports Chart 18Above-Trend Growth In Global Industrial Production Will Also Support Chinese Exports Above-Trend Growth In Global Industrial Production Will Also Support Chinese Exports Above-Trend Growth In Global Industrial Production Will Also Support Chinese Exports Bottom Line: China’s producers will continue to pass on inflation to their domestic and foreign customers. Chart 19Chinese Export Prices Are Below Global Average Chinese Export Prices Are Below Global Average Chinese Export Prices Are Below Global Average Chart 20Favor CSI500 Index Over A-Shares Favor CSI500 Index Over A-Shares Favor CSI500 Index Over A-Shares Investment Conclusions China’s authorities will unlikely use policy measures to cool domestic demand, but they will be constrained by lingering inflationary risks driven by external consumption and supply-side pressures in the next six months. Monetary and fiscal policies will ease to counter the slowdown in the economy, but reflationary measures will be gradual. We expect the money and credit impulse to bottom in Q4, but the rebound will be subdued. As such, domestic demand will remain sluggish and economic growth will likely decelerate faster than the onshore market has currently discounted. While we maintain a cautious stance on Chinese stocks in general, we continue to favor the CSI500 Index relative to the broader A-share market. External demand growth may remain above trend in the next six months. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market, and should still have some upside potentials. (Chart 20).   Jing Sima China Strategist jings@bcaresearch.com Market/Sector Recommendations Cyclical Investment Stance

We will be holding our quarterly webcasts next Monday, November 15th at 10:00 a.m. Eastern time and Tuesday, November 16th at 8:00 a.m. Hong Kong time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 22nd. Highlights Economy – Wages could be on the rise if workers are able to exploit the considerable leverage they now enjoy: The labor market currently has no slack. Workers’ ability to derive a lasting advantage from today’s shortages will determine if the extended decline in labor’s share of income will reverse. Markets – Lengthy agreements in labor’s favor could give inflation an additional impetus: Investors are not prepared for a shift in the balance of power from management to labor and a range of assets will have to reprice if workers can achieve some durable victories. Strategy – Keep an eye on labor agreements, which could hasten a shift to more defensive positioning: The current economic backdrop, along with accommodative monetary and fiscal policy, support risk-friendly portfolio positioning, but a labor revival could prompt the Fed to engage in a disruptive tightening cycle that would halt the bull markets in equities and credit and possibly also short-circuit the expansion. Feature At the end of 2019, tiring of the market debates du jour, we began haunting the New York Public Library, reading all we could about US labor relations history. Several books and rolls of microfilm later, we published a three-part Special Report on workers’ past, present and future. While we concluded that organized labor would not regain the influence it wielded in the fifties, sixties and seventies, we thought that investors were underestimating the potential for workers to reverse the grinding decline in their fortunes that began in the early eighties. Public opinion seemed to be shifting in workers’ favor, especially among the young; the coming election held promise for the Democrats; and the pendulum had swung so far, for so long, that there was little scope for management to gain any more ground. We looked forward to countering the view that organized labor was as dead as a doornail, only to have COVID-19 render the topic irrelevant. Nearly two years later, however, dislocations caused by the pandemic have pushed negotiations over wages and labor conditions to the fore. Amidst a recent flurry of strikes against S&P 500 constituents, clients have been asking what the labor future holds. We refresh the themes we identified in our initial analysis, noting how conditions have shifted since early 2020. The investment takeaway is that increasing labor muscle could stoke inflation and push long-run inflation expectations higher, forcing the Fed to tighten monetary policy more abruptly than markets expect. The 2020 Election Went Labor’s Way A review of the historical record makes it crystal clear that employees cannot gain ground if government sides with employers. The 2020 election, which delivered both the White House and the Senate to Democrats, put some unexpected wind in labor’s sails. They did not mark a revival of the New Deal, however, as Democrats’ legislative majorities are precariously thin and unlikely to survive the 2022 midterms, their control of the presidency may not extend beyond 2024, and the federal judiciary will be inclined to see things management’s way for some time thanks to past conservative appointments. At the state level, the executive and legislative branches remain firmly in Republican control. A friendly executive branch can do a lot to reset the scales nonetheless. The Biden Department of Labor, National Labor Relations Board (NLRB), Occupational Safety and Health Administration (OSHA) and Department of Justice are certain to enforce existing worker protection laws more vigorously than their recent predecessors, while more actively challenging business combinations. Joe Biden began his election campaign at a Pittsburgh union hall and returned to the Steel City to end it, promising to be “the most pro-union president you’ve ever seen.” Labor leaders have generally given him high marks since taking office for supporting legislation to make it easier for workers to organize and he publicly offered moral support to John Deere’s UAW workers when they went on strike last month, saying, “My message is they have a right to strike and they have a right to demand higher wages.” Public Opinion Has Continued To Shift Toward Labor We noted two years ago that young Democratic voters overwhelmingly favored Bernie Sanders’ and Elizabeth Warren’s candidacies, suggesting that solidarity with workers might be on the rise. It is no surprise that students would be the most avid supporters of progressive campaigns, but Millennials, born between 1981 and 1996, and Generation Z might be viewed as the Inequality Generations, having entered the workforce after China’s admittance to the WTO, which coincided with a peak in labor’s share of income (Chart 1). Their lives have spanned the September 11th attacks, the financial crisis, a once-in-a-century pandemic and three equity market crashes, and many of them started adulthood with onerous student debt burdens and dim earnings prospects. They might find the notion of a union buffer from market forces especially alluring and therefore view unions favorably. The 2019 Gallup poll found that public approval for unions had reached nearly 20-year highs; two years on, it’s up to levels last reached over 50 years ago (Chart 2). Chart 1Workers' Share Of The Pie Shrank For 15 Years Workers' Share Of The Pie Shrank For 15 Years Workers' Share Of The Pie Shrank For 15 Years Chart 2Extreme Makeover Extreme Makeover Extreme Makeover Public opinion is crucially important to the outcome of labor negotiations because for-profit employers will seek the most favorable terms they can get, to the extent that they are socially acceptable. In our schematic of the 1980s vicious circle that initiated unions’ 40-year decline, public opinion made it possible for the Reagan administration to take a hard line against the air traffic controllers’ union and emboldened private employers to take more aggressive measures as well (Figure 1). Beyond the private sector, elected officials reliably deliver what their constituents want, and the courts do, too, albeit with a longer lag. The median voter theory advanced by our geopolitical strategists doesn’t just predict future outcomes, it directly influences them. Chart Striketober Another key takeaway from our original study was that successful strikes beget strikes. Strikes are the most potent weapon in workers’ arsenal – withholding their labor threatens to reduce their employer’s output and may halt it altogether – but they are fraught with risk for individual employees. Striking workers don’t get paid beyond the partial support that may be provided by their union strike fund and may find themselves entirely out of work if the strike fails. Workers should only strike when they have a good chance of winning or when their situation has become so intolerable that they have little to lose. Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative position, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. Viewing labor negotiations through a game theory lens, we posit a simple framework in which each side can hold any of five perceptions of its bargaining power, resulting in a total of 25 possible joint perceptions. Labor (L) can believe it is way stronger than Management (M), L >> M; stronger than Management, L > M; roughly equal, L ≈ M; weaker than Management, L < M; or way weaker than Management, L << M. Management also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure 2 displays only the outcomes consistent with labor’s belief that it has the upper hand. For completeness, the exhibit lists all of management’s potential perceptions, but we deem the three away from the extremes to be most likely. Record job openings and job quits rates (Chart 3) should disabuse even the most rabidly anti-union managements from thinking they hold all the cards. On the other hand, four consecutive decades of victories will make it hard for all but the most objective management negotiators to believe that the tables have completely turned and that labor is fully in control. Chart Chart 3It's A Labor Seller's Market ... It's A Labor Seller's Market ... It's A Labor Seller's Market ... Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack Though we hold the view that labor force participation is likely to revive in coming months because inequality and a comparatively thin social safety net will compel many lower-income workers to return to the work force, no one knows for sure where the workers have gone or when they will return, if at all. It is abundantly clear from accelerating wage gains (Chart 4), the openings and quits rates, and small businesses’ historic inability to fill job openings (Chart 5) that the labor market is extremely tight right now. A difference of opinion about whether and how long the worker shortages will persist could make finding common ground in contract negotiations a challenge. Chart 4... As Rising Wages ... ... As Rising Wages ... ... As Rising Wages ... Chart 5... And Frantic Employers Confirm ... And Frantic Employers Confirm ... And Frantic Employers Confirm Economic Concentration We previously noted that the trend toward economic concentration has strengthened management’s hand in labor negotiations as it has made an increasing share of local labor markets tend toward monopsony. A monopsony is a market with a single buyer, the mirror image of a monopoly, which is a market with a single seller. Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. The trend toward economic concentration is well established and we think the probability that it will reverse is low – Congress may shake its fist at Big Tech and the Biden Justice Department will more vigorously contest mergers on anti-trust grounds, but there is an ocean of liquidity available to support acquisitions and robust CEO confidence suggests it will be deployed. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from statehouses, federal agencies and the courts, as union and labor protections have been under siege from all sides. But the regulatory and legal tide has been such a huge benefit for employers since the beginning of the Reagan administration that it simply cannot continue to maintain its pace. Furthermore, as our Global Investment Strategy colleagues have observed, the Republican party’s lurch toward populism may leave Big Business without a champion in Washington, DC. The regulatory and legal winds are shifting and management teams that have spent their entire careers in an environment in which labor has perpetually been on the back foot may be the last to know, leading to an uptick in the number and contentiousness of labor disputes. A change in Fed policy, as unveiled in the August 2020 revision to the FOMC’s statement on longer-run monetary policy goals, has also tilted the playing field in workers’ favor. The Fed has sworn off preemptively tightening monetary policy when the labor market appears to be getting tight. The new direction contrasts with 40-plus years of Fed policy that were predicated on taking away the punch bowl before upward wage pressures could build momentum. The tacit pledge in the revised statement on monetary policy implies that the Fed will prioritize its full employment mandate over its price stability mandate in the near term. That’s not an unalloyed positive for workers, who will only be better off if their nominal wage gains outpace inflation, but it will help give them more of a head start than they would have gotten if the FOMC had stuck with the proposition that tight labor markets stoke inflation. The Labor-Management Rubber Band Employees and employers have a deeply symbiotic relationship, and we like to think of labor and management as being linked by an elastic tether with a finite range. Since neither side can indefinitely thrive if the other is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. One does not have to be a card-carrying socialist to believe that the band is near its limit and that some sort of mean reversion is inevitable, given how badly real hourly wages have lagged gains in hourly output over the last 50 years (Chart 6). Chart 6Testing How Far The Labor-Management Rubber Band Can Stretch Testing How Far The Labor-Management Rubber Band Can Stretch Testing How Far The Labor-Management Rubber Band Can Stretch What Comes Next Steady concentration across industries and a persistently hospitable legal and regulatory climate has given management the upper hand for four decades. Going forward, however, labor should see its fortunes improve as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band becomes less stretched in management’s favor (Figure 3). Chart The major uncertainty pertains to the ongoing level of slack in the labor market and how employment agreements should account for it. All parties recognize there is no slack right now and employers are duly offering generous inducements to attract workers. Sign-on bonuses for new employees in unskilled services positions are ubiquitous and negotiations with unionized employees include ratification bonuses for signing new contract packages. Because wages are sticky on the downside – it’s difficult to get employees to swallow outright pay cuts – employers prefer making one-time concessions like bonuses to increasing wage rates across the board, which is tantamount to locking in higher long-term input costs. The duration of concessions appears to be a sticking point in the negotiations to settle the current strikes. Over the last two decades, several large companies with unionized workforces have instituted a two-tier employment track distinguishing legacy employees from new hires. The legacy employees remain on their existing salary path and retain their retirement and health insurance benefits, while new employees are subject to a lower salary scale and are entitled to fewer benefits, if any. The result has been to bend the human resources cost curve lower in the future as natural attrition shrinks the share of employees on the more costly legacy path. The two-tier employment classification has proven to be an effective way for employers to bend the cost curve to their liking, as it protects the interests of a considerable majority of employee voters at the expense of a largely hypothetical future employee constituency. It is presumably difficult to empathize with workers who aren’t yet coming to the plant every day and legacy employees haven’t dwelled on their plight when participating in contract ratification votes. An interesting feature of the ongoing John Deere strike is that the UAW rejected what appeared to be a strikingly generous package partially in the interest of defending current and future employees who have no path to reach legacy employees’ all-in compensation level. The recent strikes against S&P 500 constituents have been concentrated in industries that faced demand spikes during the pandemic. The bakery worker’s union (BCTGM) representing Kellogg’s workers struck against Frito-Lay (owned by Pepsi) for three weeks in July and Nabisco (a unit of Mondelez) for five weeks in August and September. A significant motivation for the BCTGM workers’ actions seemed to be frustration over intense pandemic workloads. Their plants ramped up capacity to fill kitchen cabinets while consumers were cooped up at home and they are now seeking redress for the emergency hours they were asked to work. (All of the bakery workers who struck, as well as the John Deere workers, were considered essential workers.) Management, on the other hand, might take the view that their employees’ sacrifices are in the past, and are not likely to be repeated if product demand settles back into its pre-pandemic trend. Viewing ongoing negotiations from our game theory perspective, there is ample room for divergent perceptions of relative negotiating strength, based on differing opinions about the persistence of pandemic trends. The divergence might make for increasingly contentious labor negotiations going forward, with strikes exacerbating supply bottlenecks and ramping up near-term inflation pressures. If ongoing rounds of labor negotiations result in workers achieving longer-term victories, it will pressure corporate profit margins. Labor gains will also potentially feed into inflation if capacity is not poised to meet the ensuing increase in aggregate demand. We will keep close tabs on labor negotiations as the economy works its way back to a post-pandemic steady state.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Highlights Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. Unlike in the late 1990s, when rising wages were counterbalanced by robust productivity gains, most of the recent rebound in US productivity growth will prove to be illusory. US inflation will follow a “two steps up, one step down” trajectory. We are currently at the top of those two steps, but rising unit labor costs will eventually drive inflation higher. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted. Such an inversion does not make sense to us. Hence, we are initiating a trade going long the 20-year bond versus the 30-year bond. Go short the 10-year Gilt on any break below 0.85%. UK real bond yields are amongst the lowest in the world. The Bank of England will eventually have to turn more hawkish, which will support the beleaguered pound. Structurally higher bond yields will benefit value stocks. Banks stand to gain from rising bond yields while tech could suffer. The eventual re-emergence of supply-side pressures will catalyze more investment spending. This will bolster industrial stocks. The Supply Side Matters, Again Savings glut, secular stagnation; call it what you will, but for the better part of two decades, the global economy has faced a chronic shortfall of aggregate demand. Times are changing, however. The predominant problem these days is not a lack of spending; it is a lack of production. Unlike during the Global Financial Crisis – when worries about moral hazard complicated efforts to bail out homeowners and banks – the victims of the pandemic elicited sympathy. As a result, governments in developed economies rolled out a slew of measures to support workers and businesses. Thanks to bountiful fiscal transfers, households in the US have accrued $2.2 trillion in income since the start of the pandemic, about $1.2 trillion more than one would have expected based on the pre-pandemic trend (Chart 1). With many services unavailable, consumers diverted spending towards manufactured goods. At first, sellers were able to dip into their inventories to meet rising demand. By early this year, however, inventories had been depleted (Chart 2). Shortages began to pop up across much of the global supply chain. Chart 1Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Stimulus-Supported Income Growth Boosted Goods Consumption Chart 2The Pandemic Depleted Inventories The Pandemic Depleted Inventories The Pandemic Depleted Inventories While today’s empty warehouses can be largely attributed to surging demand for goods, supply-side disruptions have also played an important role. Four disruptions stand out: 1) semiconductor shortages; 2) transportation bottlenecks; 3) inadequate energy supplies; and 4) reduced labor force participation. Let us examine all four in turn. Semiconductor Shortages Chart 3Car Prices Have Jumped Car Prices Have Jumped Car Prices Have Jumped The global supply chain was not equipped to handle the dislocations caused by the pandemic. The combination of just-in-time inventory systems and far-flung supplier networks ensured that bottlenecks in one part of the global economy quickly filtered down to other parts of the economy. Few industries are as important as semiconductors. The auto sector has felt the brunt of the chip shortage. Both new and used vehicle prices have soared as dealer lots have emptied out (Chart 3). The drop in vehicle spending alone shaved 2.4 percentage points off US real GDP growth in the third quarter. Semiconductor makers have ramped up production to meet growing demand. The US Census Bureau’s Quarterly Survey of Plant Capacity Utilization showed that semiconductor plants operated an average of 73 hours per week in the first half of this year, up from around 45-to-50 hours prior to the pandemic (Chart 4). Chip production in Northeast Asia has rebounded (Chart 5). Southeast Asian production dropped in August due to Covid lockdowns, with semiconductor exports falling by over a third in Malaysia and Vietnam. Fortunately, since then, a decline in Covid cases and rising vaccination rates have spurred a recovery throughout the region. Chart 4Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chipmakers Are Working Overtime Chart 5Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Semiconductor Production Has Accelerated In Northeast Asia Chart 6Memory Chip Prices Are Declining Memory Chip Prices Are Declining Memory Chip Prices Are Declining Commentary from semiconductor companies and automakers suggest that the chip shortage will ease over the coming months. In an auspicious sign, US auto sales jumped to 13.1 million in October from 12.3 million in September. Memory chip prices are also falling (Chart 6). Nevertheless, the overall chip market is unlikely to return to balance until 2023. Transportation Bottlenecks Unlike semiconductors and high-end electronics, which usually arrive by air, bulkier items such as furniture, sporting goods, and housing appliances typically arrive by sea. Port congestion, insufficient warehouse capacity, and a lack of truck chassis on which to place containers have all contributed to transportation bottlenecks. Chart 7Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? Transportation Bottlenecks: Past The Worst? As with the semiconductor shortage, we are probably past the worst point in the shipping crisis. Drewry’s composite World Container Index has edged down 11% from its highs, although it is still up more than three-fold from mid-2020 levels (Chart 7). The easing in container shipping costs follows a dramatic 47% decline in the Baltic Dry Index since early October. The number of ships waiting to unload cargo off the coast of Los Angeles and Long Beach remains near record highs (Chart 8). Port congestion should ease over the next few months. US port throughput usually falls starting in the late fall and remains weak during the winter months, bottoming shortly after the Chinese New Year. If throughput remains elevated near current levels this year, this should be enough to clear much of the backlog. Looking further out, shipping costs could face additional downward pressure. Chart 9 shows that the number of container ships on order has risen to a 10-year high; these new ships will be delivered over the next two years. Chart 8Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Port Congestion Should Ease Over The Coming Months Chart 9Shipbuilders Are Busy Shipbuilders Are Busy Shipbuilders Are Busy Inadequate Energy Supplies After a torrid rally since the start of the year, energy prices have come off their highs. The price of Brent oil has dipped 6% from its October peak. US natural gas prices have retreated 11%. Natural gas prices in Europe have fallen 37%. Chart 10 The biggest move has been in coal prices, which have dropped 36% over the past two weeks alone. Futures curves are pricing in further declines in key energy prices (Chart 10). BCA’s Commodity and Energy Strategy service expects energy prices to soften over the next 12 months, but not as much as markets are discounting. Their latest forecast calls for the price of Brent crude to average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl), and $81/bbl in 2023 (versus market expectations of $71/bbl). As we discussed a few weeks ago, years of underinvestment have led to tight supply conditions across the entire energy complex (Chart 11). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 12). Chart 11 Chart 12   With little spare capacity, energy markets have become increasingly vulnerable to shocks. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies, while a lack of wind reduced energy production by European wind farms. Increased gas imports from Russia could have mitigated the problem, but the dispute over the Nord Stream 2 pipeline prevented that from happening. The pipeline is popular with German voters (Chart 13). BCA’s geopolitical team expects it to be approved, a welcome development given that La Niña is highly likely to lead to colder-than-normal temperatures across northern Europe this winter. Chart 13 China has also restarted 170 coal mines and will probably begin re-importing Australian coal. Beijing is also allowing utilities to charge higher prices, which should help stave off bankruptcies across the sector. These measures should help mitigate China’s energy crisis. Chart 14US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels US Rig Count Has Risen From Low Levels A bit more oil production will also help. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 14). BCA’s commodity strategists expect output in the Lower 48 states to average 9.5mm b/d in 2022 and 10mm b/d in 2023, versus 2021 production levels of 9.0mm b/d. Nevertheless, shale producers are a lot more disciplined these days. Debt reduction and cash flow generation are now the top priorities. This implies that fairly high oil prices may be necessary to catalyze additional investment in the industry.  Reduced Labor Force Participation Despite the rapid economic recovery, US employment remains 5 million below its pre-pandemic peak. One would not know this from the survey data, however. A record 51% of small businesses expressed difficulty finding qualified workers in the October NFIB survey. The share of households reporting that jobs are plentiful versus hard-to-get has returned to its 2000 highs. Both the quits rate and the job openings rate are well above their pre-pandemic levels (Chart 15). A wave of early retirement accounts for some of the apparent labor market tightness. About 1.3 million more workers have retired since the pandemic began than one would have expected based on demographic trends. Yet, there is more to the story than that. The labor force participation rate for workers aged 25-to-54 has not fully recovered; the employment-to-population ratio for that age cohort is still 2.5 percentage points below pre-pandemic levels (Chart 16). Chart 15 Chart 16Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise Labor Force Participation Has Room To Rise   There is considerable uncertainty about how many workers will re-enter the labor force over the coming months. On the one hand, the expiration of enhanced unemployment benefits could prod more workers into the job market. Diminished anxiety about the virus should help. While the number has fallen by half, there are still 2.5 million people not working due to concerns about getting or spreading Covid-19 (Chart 17). According to Boston College’s Center for Retirement Research, the retirement rate rose more for older lower-income workers than higher-income workers (Chart 18). Some of these retirees may decide to re-enter the labor force. Chart 17Less Anxiety About The Coronavirus Should Increase Labor Supply Poorer Older Workers Were More Likely To Retire Last Year Poorer Older Workers Were More Likely To Retire Last Year Chart 18   On the other hand, the imposition of vaccine mandates could reduce labor supply. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Perhaps the biggest question mark is over whether the pandemic will lead to permanent changes in peoples’ perspectives on the optimal work/life balance. High burnout rates (especially in the health care sector), a reluctance to restart the daily commute to the office, and the desire to spend more time with family have all contributed to what some commentators have dubbed The Great Resignation. Ultimately, the deciding factor may be wages. Wage growth accelerated during the late 1990s as the labor market tightened (Chart 19). This drew a lot of people – especially less-skilled workers – into the labor force. Recently, wage growth has exploded at the bottom end of the income distribution, and our guess is that this will entice more people to seek employment (Chart 20). Chart 19Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Wage Growth Accelerated During The Late 1990s As The Labor Market Tightened Chart 20Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly     Will Higher Productivity Growth Mitigate Supply-Side Pressures? The late 1990s saw a resurgence in productivity growth. This helped restrain unit labor costs in the face of rising wages. Chart 21 While US productivity did jump during the pandemic, we are sceptical of claims that this can be attributed to efficiency gains from digitalization and work-from-home practices. A recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. It is telling that productivity outside of the US generally declined during the pandemic (Chart 21). This suggests that last year’s productivity gains stemmed mainly from increased operating leverage, a common feature of post-recession US recoveries (Chart 22). Supporting this view is the fact that productivity growth slowed from 4.3% in Q1 to 2.4% in Q2 on a quarter-over-quarter annualized basis. Productivity declined by 5% in Q3, leading to an 8.3% increase in unit labor costs. Chart 22US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions US Productivity Tends To Jump After Recessions Chart 23Capital Goods Orders Have Soared Capital Goods Orders Have Soared Capital Goods Orders Have Soared The only saving grace is that core capital goods orders have soared (Chart 23). This should translate into increased business capital spending next year and higher productivity down the road. Investment Implications Supply-side pressures should abate over the coming months as semiconductor availability improves, transportation bottlenecks ease, energy prices recede, and more workers enter the labor force. The respite from inflation will be temporary, however. The combination of easy fiscal and monetary policies will cause unemployment to fall below its equilibrium level in the US, and eventually, in most major economies. This is consistent with our “two steps up, one step down” projection for US inflation. We are probably near the top of those two steps at present. This implies that the next move for inflation is to the downside, even if the longer-term trend is still to the upside. The US 10-year Treasury yield should stabilize at around 1.8% in the first half of 2022, before moving higher later in the year. As we discussed last week, markets are understating the true level of the neutral rate of interest. Rather than fretting that the Federal Reserve will keep rates too low for too long, investors are worried that the Fed will tighten too much. This is a key reason why the 20-year/30-year Treasury slope has inverted (Chart 24). Such an inversion does not make sense to us. Hence, as of this week, we are initiating a trade going long the 20-year bond versus the 30-year bond. We would also go short the 10-year Gilt on any break below 0.85%. The Bank of England’s “surprising hold” knocked the yield down 14 basis points to 0.93%. UK real bond yields are amongst the lowest in the world (Chart 25). Growth is strong and will remain buoyant as Brexit headwinds fade. The BoE will eventually have to turn more hawkish, which will support the beleaguered pound. Chart 24Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Go Long US 20-Year Bonds Versus 30-Year Bonds Chart 25UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World UK Real Bond Yields Are Amongst The Lowest In The World   Structurally higher bond yields will benefit value stocks. Chart 26 shows that there has been a close correlation between the US 30-year Treasury yield and the relative performance of global value versus growth stocks. Banks stand to gain from rising bond yields while tech could suffer (Chart 27). Chart 26Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Higher Bonds Yields Favor Value Stocks Chart 27     The re-emergence of supply-side pressures could affect companies in a variety of unexpected ways. For example, Facebook and Google both rely heavily on revenue from advertising. But what is the point of trying to boost demand for your product if you already cannot produce enough of it? Companies such as Hershey and Kimberly-Clark are already cutting ad spending in response to supply-chain bottlenecks. Finally, tight supply conditions will catalyze more investment spending. This will benefit industrial stocks. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Chart 28 Special Trade Recommendations The Supply Side Strikes Back The Supply Side Strikes Back Current MacroQuant Model Scores Chart 29

Image The markets were deluged by a lot of information in late October. Several central banks made surprise moves towards tightening (the Bank of Canada, for example, ended asset purchases, and the Reserve Bank of Australia effectively abandoned its yield-curve control). Inflation continued to surprise on the upside (headline CPI in the US is now 5.4% year-on-year). But, at the same time, there were signs of faltering growth with, for example, US real GDP growth in Q3 coming in at only 2.0% quarter-on-quarter annualized, compared to 6.7% in Q2. This caused a flattening of the yield curve in many countries, as markets priced in faster monetary tightening but lower long-term growth (Chart 1). Nonetheless, equities shrugged off the barrage of news, with the S&P500 ending the month at a new high. All this highlights what we discussed in our latest Quarterly: That the second year of a bull market is often tricky, resulting in lower (but still positive) returns from equities and higher volatility. For risk assets to continue to outperform, our view of a Goldilocks environment needs to be “just right”: The economy must not be too hot or too cold. We think it will be – and so stay overweight equities versus bonds. But investors should be aware of the risks on either side. How too hot? Inflation is broadening out (at least in the US, UK, Australia and Canada, though not in the euro zone and Japan) and is no longer limited to items which saw unusually strong demand during the pandemic but where supply is constrained (Chart 2). Chart 1What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? Chart 2Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US There is a risk that this turns into a wage-price spiral as employees, amid a tight labor market, push for higher wages to offset rising prices. We find that wages tend to follow prices with a lag of 6-12 months (Chart 3). The Atlanta Fed Wage Tracker (good for gauging underlying wage pressures since it looks only at employees who have been in a job for 12 months or more) is already at 3.5% and looks set to rise further. On the back of these inflationary moves, the market has significantly pulled forward the date of central bank tightening. Futures now imply that the Fed will raise rates in both July and December next year (Chart 4) and that other major developed central banks will also raise multiple times over the next 14 months (Table 1). Breakeven inflation rates have also risen substantially (Chart 5). Chart 3Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Chart 4Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon?   Table 1Futures Implied Path Of Rate Hikes Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks Chart 5Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation     We think these moves are a little excessive. There are several reasons why inflation might cool next year. Companies are rushing to increase capacity to unblock supply bottlenecks. For example, semiconductor production has already begun to increase, bringing down DRAM prices over the past few months (Chart 6). Another big contributor to broad-based inflation has been a 126% increase in container shipping costs since the start of the year (Chart 7). But currently the number of container ships on order is at a 10-year high; these new ships will be delivered over the next two years. Such deflationary forces should pull down core inflation next year (though we stick to our longstanding view that for multiple structural reasons – demographics, the end of globalization, central bank dovishness, the transition away from fossil fuels – inflation will trend up over the next five years). Chart 6DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up Chart 7All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs The Fed, therefore, will not be in a rush to raise rates. It does not see the labor market as anywhere close to “maximum employment” – it has not defined what it means by this, but we would see it as a 3.8% unemployment rate (the median FOMC dot for the equilibrium unemployment rate) and the prime-age participation rate back to its 2019 level (Chart 8). We continue to expect the first rate hike only in December next year. The Fed will feel the need to override its employment criterion only if long-term inflation expectations become unanchored – but the 5-year 5-year forward breakeven rate is only at 2.3%, within the Fed’s effective CPI target range of 2.3-2.5% (Chart 5). We remain comfortable with our view of only a moderate rise in long-term rates, with the US 10-year Treasury yield at 1.7% by end-2021, and reaching 2-2.25% at the time of the first Fed rate hike. It is also worth emphasizing that even a fairly sharp rise in long-term rates has historically almost always coincided with strong equity performance (Chart 9 and Table 2). This has again been evident in the past 12 months: When rates rose between August 2020 and March 2021, and then from July 2021, equities performed strongly. Chart 8We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" Chart 9Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market   Table 2Episodes Of Rising Long-Term Rates Since 1990 Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks But could the economy get too cold? We would discount the weak US GDP reading: It was mostly due to production shortages, especially in autos, which pushed down consumption on durable goods by 26% QoQ annualized, and by some softness in spending on services due to the delta Covid variant, the impact of which is now fading. US growth should continue to be supported by a combination of the $2.5 trillion of excess household savings, strong capex as companies boost their production capacity, and a further 5% of GDP in fiscal stimulus that should be passed by Congress by year-end. Similar conditions apply in other developed economies. Chart 10Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP We see three principal risks to this positive outlook: A new strain of Covid-19 that proves resistant to current vaccines – unlikely but not impossible. Our geopolitical strategists worry about Iran, which may have a nuclear bomb ready by December, prompting Israel to bomb the country. Iran would likely react by hampering oil supplies, even blocking the Strait of Hormuz, through which 25% of global oil flows. Chinese growth has been slowing and the impact from the problems at Evergrande is still unclear. Real estate is a major part of the Chinese economy, with residential investment comprising 10% of GDP (Chart 10) and, broadly defined to include construction and building materials, real estate overall perhaps as much as one-third. Our China strategists don’t expect the government to launch a major stimulus which would bail out the industry, since it is happy with the way that property-related lending has been shrinking in recent years (Chart 11). We expect the slowdown in Chinese credit growth to bottom out over the coming few months, but economic activity may have further to slow (Chart 12), and there is a risk that the authorities are unable to control the fallout from the property market. Chart 11Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chart 12When Will Credit Growth Bottom? When Will Credit Growth Bottom? When Will Credit Growth Bottom?       Fixed Income: Given the macro environment described above, we remain underweight bonds and short duration. If we assume 1) a Fed liftoff in December 2022, 2) 100 basis points of rate hikes over the following year, and 3) a terminal Fed Funds Rate of 2.08% (the median forecast from the New York Fed’s Survey of Market Participants), 10-year US Treasurys will return -0.2% over the next 12 months, and 2-year Treasurys +0.3%.1 TIPs have overshot fair value and, although we remain neutral since they a tail-risk hedge against high inflation over the next five years, we would especially avoid 2-year TIPS which look very overvalued. We see some pockets of selective value in lower-quality high-yield bonds, specifically US Ba- and Caa-rated issues, which are still trading at breakeven spreads around the 35th historical percentile, whereas higher-rated bonds look very expensive (Chart 13). For US tax-paying investors, municipal bonds look particularly attractive at the moment, with general-obligation (GO) munis trading at a duration-matched yield higher than Treasurys even before tax considerations (Chart 14). Our US bond strategists have recently gone maximum overweight. Chart 13 Chart 14Muni Bonds Are A Steal Muni Bonds Are A Steal Muni Bonds Are A Steal     Equities: We retain our longstanding preference for US equities over other Developed Markets. US equities have outperformed this year, irrespective of whether rates were rising or falling, or how US growth was surprising relative to the rest of the world, emphasizing the much stronger fundamentals of the US market (Chart 15).  Analysts’ forecasts for the next few quarters look quite cautious, and so earnings surprises can push US stock prices up further (Chart 16). We reiterate the neutral on China but underweight on Emerging Markets ex-China that we initiated in our latest Quarterly. Our sector overweights are a mixture of cyclicals (Industrials), rising-interest-rate plays (Financials), and defensives (Heath Care). Chart 15US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened Chart 16Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters   Currencies: We continue to expect the US dollar to be stuck in its trading range and so stay neutral. Recent moves in prospective relative monetary policy bring us to change two of our currency recommendations. We close our underweight on the Australian dollar. The recent rise in Australian inflation (with both trimmed mean and 10-year breakevens now above 2% – Chart 17) has brought forward the timing of the first rate hike and should push up relative real rates (Chart 18). We lower our recommendation on the Japanese yen from overweight to neutral. The Bank of Japan will not raise rates any time soon, even when other central banks are tightening. This will push real-rate differentials against the yen (Chart 18, panel 2). Chart 17Australian Inflation Is Picking Up Australian Inflation Is Picking Up Australian Inflation Is Picking Up Chart 18Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Chart 19Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Commodities: We remain cautious on those industrial metals which are most sensitive to slowing Chinese growth and its weakening property market. The fall in iron ore prices since July is now being followed by aluminum. However, metals which are increasingly driven by investment in alternative energy, notably copper, are likely to hold up better (Chart 19). We are underweight the equity Materials sector and neutral on the commodities asset class. The Brent crude oil price has broadly reached our energy strategists’ forecasts of $80/bbl on average in 2022 and $81 in 2023 (Chart 20). Although the forward curve is lower than this, with December-22 Brent at only $75/bbl, it is a misapprehension to characterize this as the market forecasting that the oil price will fall. Backwardation (where futures prices are lower than spot) is the usual state of affairs for structural reasons (for example, producers hedging production forward). The market typically moves to contango only when the oil price has fallen sharply and reserves are high (Chart 21). We remain neutral on the equities Energy sector.   Chart 20Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Chart 21Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation