Inflation/Deflation

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Chart 2Natgas Storage Remains Tight Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 BRENT PRICES BEING VOLATILE BRENT PRICES BEING VOLATILE Chart 6 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Investment Grade: Investment grade corporate bond total returns will be close to zero or negative during the next 12 months. The bonds are also likely to outperform duration-matched Treasuries during that period, but excess returns are probably capped at 85 bps. High-Yield: High-yield total returns will fall between -0.29% and +1.80% during the next 12 months, but with a much higher likelihood of being positive than investment grade corporates. Junk will outperform duration-matched Treasuries by between 0.94% and 1.84%, besting the excess returns earned in investment grade. Inflation & The Fed: The Fed will announce asset purchase tapering before the end of this year, and tapering will proceed at a pace that opens the door to a potential rate hike before the end of 2022. Ultimately, whether the Fed lifts rates in 2022 will depend on trends in core CPI excluding COVID-impacted services and autos, along with wage growth and inflation expectations. Feature Chart 1Valuations Are Stretched Valuations Are Stretched Valuations Are Stretched There are two broad factors that must be considered when deciding whether to favor corporate bonds over Treasuries in a US bond portfolio: (i) The cyclical macroeconomic environment and (ii) valuation. The problem is that, as it stands today, these two factors are sending contrasting signals. The cyclical macroeconomic environment is consistent with strong positive excess returns for spread product versus Treasuries. However, corporate bond spreads and yields are extremely low relative to history (Chart 1). We view the slope of the yield curve as the single best indicator of the cyclical macro environment and have shown in prior research that corporate bonds tend to deliver positive excess returns versus Treasuries when the 3-year/10-year Treasury slope is above 50 bps, even when corporate spreads are tight.1 At present, the 3-year/10-year slope sits at 90 bps and our bias will be toward an overweight allocation to corporates until the slope breaks below 50 bps. A flatter yield curve is negative for corporate bond performance because it suggests that monetary conditions are less accommodative. It also makes it more likely that an unforeseen shock will lead to yield curve inversion, a highly reliable recession indicator. While the macro environment is consistent with continued corporate bond outperformance versus Treasuries, valuation suggests that we should anticipate lower returns than usual from corporate bonds. Table 1 shows annualized corporate bond excess returns during each of the past six cycles. Additionally, it splits each cycle into three phases based on the slope of the 3-year/10-year Treasury curve. Phase 1 of the cycle lasts from the end of the prior recession until the slope breaks below 50 bps. Phase 2 encompasses the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Table 1Corporate Bond Excess Returns In Different Phases Of The Cycle Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds The first conclusion to draw from Table 1 is that excess returns tend to be lower in Phase 2 than in Phase 1 and lower in Phase 3 than in Phase 2. Second, we see that investment grade corporates have returned an annualized 7.55% in excess of duration-matched Treasuries so far this cycle and high-yield corporates have delivered 15.15% of outperformance. These figures are well above even those seen in prior Phase 1 periods. Based on this, an expectation for lower – but still positive – excess corporate bond returns seems like a reasonable base case for the next 6-12 months. Table 2 is identical to Table 1 except that it shows total returns instead of excess returns. We observe that, so far this cycle, junk bond total returns have outpaced prior Phase 1 periods. Investment grade total returns have been slightly lower given the greater exposure to interest rate risk of those securities. Table 2Corporate Bond Total Returns In Different Phases Of The Cycle Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds As noted above, our expectation is that corporate bonds will outperform Treasuries during the next 6-12 months, but that both excess returns and total returns will take a step down. The next section of this report presents a scenario analysis that puts some more specific numbers on the sorts of excess and total corporate bond returns investors might expect to earn during the next year. Corporate Bond Returns: Scenario Analysis Methodology To run our scenario analysis for investment grade corporate bond returns we use the following equations: Excess Return = OAS0  – D0 (dOAS) Total Return = OAS0+ TSY0 – D0 (dOAS+dTSY) Where: Excess Return = The expected corporate index excess return versus duration-matched Treasuries during the next 12 months Total Return = The expected corporate index total return during the next 12 months OAS0 = Today’s average index option-adjusted spread D0 = Today’s average index duration TSY0 = Today’s Treasury yield that matches the duration of the corporate index dOAS = The expected change in the index option-adjusted spread during the next 12 months dTSY = The expected change in the duration-matched Treasury yield during the next 12 months These equations are obviously simplifications. For example, the impact of convexity is ignored. However, Chart 2 shows that our proxies track actual index returns very closely over time, assuming the estimated yield and spread changes are accurate. Chart 2Estimating IG Returns Estimating IG Returns Estimating IG Returns We use similar equations for assessing high-yield corporate returns, with the additional complication that we must include an assumption for default losses. Excess Return= OAS0 – (DR × (1 - RR)) –D0(dOAS) Total Return= OAS0 + TSY0 – (DR × (1 – RR)) –D0 (dOAS + dTSY) In these equations: DR = The expected issuer-weighted default rate for the next 12 months RR = The expected average recovery rate on defaulted debt for the next 12 months Once again, though these equations are relatively simple, they do a good job of capturing actual returns over time (Chart 3). Chart 3Estimating HY Returns Estimating HY Returns Estimating HY Returns Scenarios With the above equations in hand, we can easily make some educated guesses about future yields, spreads and default losses and translate those assumptions into expected return forecasts. Specifically, we test three different scenarios (bullish, neutral and bearish) for corporate spreads, Treasury yields and default losses. For corporate index spreads, both investment grade and high-yield, our bullish scenario assumes that spreads reach the all-time tight levels seen in the mid-1990s. For investment grade bonds this spread level is 58 bps, 27 bps below the current level. For high-yield bonds this spread level is 233 bps, 41 bps below the current level. Our neutral scenario assumes that index spreads remain at their current levels (85 bps for investment grade and 274 bps for junk). Finally, our bearish scenario assumes that spreads widen back to the average levels seen during the 2017-2019 period (112 bps for investment grade and 369 bps for junk), this implies 27 bps of widening for investment grade and 95 bps of widening for junk. Given our view that bond yields will rise as we approach the next Fed tightening cycle, none of our scenarios assume that Treasury yields will fall during the next 12 months. Our bullish Treasury yield scenario assumes that yields stay flat at current levels. Our neutral Treasury yield scenario assumes that yields follow the path implied by current forward rates, and our bearish Treasury yield scenario assumes that yields rise to levels consistent with fair value estimates assuming the market prices-in a December 2022 Fed liftoff followed by 100 bps of rate hikes per year until the fed funds rate levels-off at 2.08%.2 We use the 7-year and 6-year Treasury yields as our inputs for the investment grade and high-yield scenarios, respectively, as those yields most closely match the interest rate component embedded in the corporate indexes. For default losses, our bullish scenario assumes a 1.8% default rate – consistent with the rate at which defaults are tracking so far this year – and a recovery rate of 50%. Our neutral scenario assumes a 3% default rate and a 40% recovery rate. Our bearish scenario assumes a 4% default rate and 30% recovery rate. Investment Grade Results Table 3 shows the results of our scenario analysis for investment grade corporate bond returns. Table 3Investment Grade Corporate Bond Expected Return Scenarios Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Starting with excess returns, we think it is most likely that spreads remain near current levels, or perhaps widen a bit, during the next 12 months. We think it’s extremely unlikely that spreads will tighten to the levels seen in the mid-1990s because the average duration of the index is much higher today than it was back then. All else equal, it’s generally true that securities with higher duration also have higher OAS. This means we expect investment grade corporate bond excess returns to be between -153 bps and +85 bps during the next 12 months, probably closer to +85 bps. Obviously, this represents a significant step down from the +550 bps earned during the past year. In fact, even the most bullish scenario where spreads tighten back to all-time lows only implies an excess return of +323 bps, well below the recent rate of outperformance. As for total returns, we estimate that a neutral scenario where the index spread holds steady and Treasury yields follow the forward curve will lead to total returns being close to zero during the next 12 months. In fact, our results suggest that it’s highly likely that investment grade corporate bonds will deliver negative total returns during the next 12 months. Yes, the index is expected to deliver a total return of 1.98% if both the index spread and duration-matched Treasury yield remain at their current levels, but an environment where growth is slow enough to keep Treasury yields flat is much more likely to coincide with spread widening than with steady corporate spreads. For some additional historical perspective, the columns labeled “Historical Percentile Rank” show how the returns in each scenario would rank relative to actual returns earned during the past 31 calendar years. For example, even the most bullish total return scenario of 4.36% ranks at the 27th percentile relative to history. This means that it would only be better than 27% of historical 12-month return observations for that index. High-Yield Results Tables 4A, 4B and 4C summarize the results of our high-yield scenario analysis. Table 4A assumes the bullish scenario for default losses, Table 4B assumes the neutral scenario for default losses and Table 4C assumes the bearish scenario for default losses. Table 4AHigh-Yield Corporate Bond Expected Return Scenarios: Bullish Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Table 4BHigh-Yield Corporate Bond Expected Return Scenarios: Neutral Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Table 4CHigh-Yield Corporate Bond Expected Return Scenarios: Bearish Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Looking at excess returns, the first result that jumps out is that even the most bullish scenario leads to an expected 12-month excess return of +3.43%, this would be equivalent to the median return earned during the past 31 calendar years. In our view, it’s more likely that excess returns will be in the +0.94% to +1.84% range during the next 12 months. This is consistent with flat spreads and a range for default losses between our neutral and bullish scenarios. Our sense is that junk bonds are less likely to deliver negative total returns than investment grade bonds. Though even the most bullish scenario puts expected junk total returns at +4.54%, consistent with the 39th percentile relative to history. Investment Implications To summarize, our expectation is that investment grade corporate bond total returns will be close to zero or negative during the next 12 months. The bonds are also likely to outperform duration-matched Treasuries during that period, but excess returns are probably capped at 85 bps. Our best guess places high-yield total returns at between -0.29% and +1.80%, but with a much higher likelihood of earning positive total returns than a position in investment grade. We estimate that excess junk returns will fall between +0.94% and +1.84%, above returns earned in investment grade. In general, the message is that investors should remain overweight corporate bonds versus Treasuries, but should retain a preference for high-yield over investment grade and should expect to earn far lower returns than were earned during the past year. Given low expected returns, investors should also seek out creative ways of adding additional spread to a bond portfolio. We offered some suggestions in a recent report.3 CPI Update And FOMC Preview This week’s FOMC meeting could be significant for bond markets. First off, there is a possibility that the Fed will announce a timeline for tapering its asset purchases. Our sense is that last month’s weak employment report probably delays this announcement, but we still expect it to come before the end of the year. We expect that the actual tapering of purchases will start in January 2022 and that net Fed purchases will reach zero by Q3 of next year. More broadly, we continue to think that the market is already priced for a tapering announcement in 2021. In other words, any information about asset purchases probably won’t move bond yields that much. What will move bond yields is any hint about when the Fed thinks it may want to start lifting rates. Such news could come in the form of revisions to the Fed’s interest rate forecasts, or in any information that the Fed provides about the pace of asset purchase tapering. Because the Fed has indicated a strong preference for having net purchases at zero prior to liftoff, any pace of tapering that gets net purchases to zero by the middle of next year opens the door to a possible rate hike before the end of 2022. Of course, the economic data between now and the end of 2022 will have a lot to say about whether the Fed actually starts to hike. In particular, last week’s report made the case that next year’s inflation data will determine when rate hikes begin.4 With that in mind, last week’s CPI release showed a significant deceleration in core inflation, driven by the COVID-impacted service and auto sectors that had previously caused inflation to spike (Chart 4). Interestingly, core inflation excluding COVID-impacted services and autos jumped on the month (Chart 4, bottom panel). From the Fed’s perspective, it ignored the transitory rise of COVID-impacted service and auto inflation on the way up, it will also be inclined to ignore its descent. What will ultimately matter for monetary policy is whether underlying inflationary pressures start to build throughout 2022. It is therefore much more important for us to focus on trends in core inflation excluding the COVID-impacted services and autos, along with wage growth and inflation expectations. Our view is that underlying inflationary pressures will be strong enough for the Fed to lift rates before the end of 2022. This will, in large part, be due to an acceleration of shelter inflation (Chart 5). Owner’s Equivalent Rent and Rent of Primary Residence inflation have already jumped, and leading indicators of shelter inflation like the unemployment rate (Chart 5, panel 3) and the Apartment Market Tightness Index (Chart 5, bottom panel) are consistent with further acceleration. Chart 4Looking For Underlying Inflation Looking For Underlying Inflation Looking For Underlying Inflation Chart 5Shelter Inflation Will Keep Rising Shelter Inflation Will Keep Rising Shelter Inflation Will Keep Rising Bottom Line: The Fed will announce asset purchase tapering before the end of this year, and tapering will proceed at a pace that opens the door to a potential rate hike before the end of 2022. Ultimately, whether the Fed lifts rates in 2022 will depend on trends in core CPI excluding COVID-impacted services and autos, along with wage growth and inflation expectations.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 Last week’s report provides more detail on this fair value analysis. Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 3 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 4 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Economy – The inflation question is unresolved, and it will remain that way for the rest of the year: August’s CPI report had something for everyone and ensured the debate will continue. Doves could celebrate the month-over-month decline while hawks could argue that upward inflation pressures are no longer a transitory phenomenon. Markets – Elevated valuations make equities vulnerable, but a little turmoil in China is not likely to trigger a de-rating wave: The demise of large Chinese property developer Evergrande may cause some upheaval in China but it is not likely to ruffle the S&P 500, corporate bonds or other US spread product. Strategy – Policymakers continue to hold the key. As long as the Fed is still easing, and households direct some of their excess savings to consumption, risk assets should outperform: We still think Goldilocks is far more likely that a too-cold or a too-hot outcome. Feature We continue to view the prospects for financial markets and the economy through a Goldilocks-and-the-two-tails lens, with the idea that equities and credit will thrive against a backdrop of supercharged growth and ongoing policy support (Figure 1). The Fed’s unusually pro-cyclical stance will prolong the macro sweet spot for risk assets and ensure positive excess returns provided growth doesn’t flop (the too-cold left tail), or the inflation genie doesn’t get out of the bottle (the too-hot right tail). Though both flanks pose a risk to our base-case Goldilocks scenario, we deem overheating to be the bigger concern. Unless a vaccine-resistant variant reestablishes COVID-19 as a mortal threat to the broad population, we think it is unlikely that growth will tumble below trend this year or next. Figure 1Goldilocks And The Two Tails Watching Both Flanks Watching Both Flanks One does not need to be a sworn devotee of rugged individualism to harbor some misgivings about the magnitude and scope of the direct transfers to American households or the broader fiscal effort to combat the economic effects of the pandemic. Egged on by support amounting to 25% of a year’s output, it remains entirely possible that aggregate demand might overwhelm productive capacity. The emergence of rolling bottlenecks in the spaces that were most crimped by COVID has focused attention on the threat of overheating, but the more lasting risk emanates from spaces that cannot be dismissed as unduly influenced by the pandemic. We have been closely monitoring the path of consumer prices and will continue to do so, but the ultimate outcome remains unclear. Though a Goldilocks macro backdrop remains our base-case expectation, it is far from assured. In this week’s report, we consider three potential disruptions: too much inflation, a change in the Fed’s policy course and a credit shock from China. We do not think that any of the potential disruptions is likely to change the picture in a material way and we therefore reiterate our view that investors with a twelve-month timeframe ought to maintain at least an equal weight exposure to equities and credit in a multi-asset portfolio. Fitting The August CPI Tile Into The Inflation Mosaic The pace of consumer price increases cooled in August, according to the headline and core CPIs. Both measures came in below market expectations, and the leading month-over-month series (Chart 1, dashed line) decelerated more than their year-over-year counterparts (Chart 1, solid line). Although the data were encouraging on their face, the ongoing inflation debate is nowhere near resolved. COVID continues to play havoc with the spaces it impacted most heavily, defying simple interpretations of aggregate CPI data. Base effects have warped year-over-year data once the peak pandemic months of last spring and summer entered the equation. As category-by-category analyses of the April CPI release showed, the lion’s share of the aggregate core CPI increase was powered by new and used cars and a handful of badly disrupted services like air travel, car rental, lodging and in-person entertainment. Chart 1Inflation Seems To Have Peaked Inflation Seems To Have Peaked Inflation Seems To Have Peaked Chart 2A Stunning Reversal On Used-Car Lots A Stunning Reversal On Used-Car Lots A Stunning Reversal On Used-Car Lots The semiconductor-driven production squeeze pushed up new car prices and took used car prices along for the ride as consumers turned to them as a ready substitute. Used car prices then rose even more as rental car companies frantically reversed 2020’s culling of their fleets to meet revived 2021 demand (Chart 2). By July, however, several of those categories had come off the boil and began to make more modest contributions to month-over-month core CPI growth. In August, they turned into headwinds, limiting core CPI’s sequential gain to just 0.1%. While the core index grew at its slowest rate since February, the segments that weren’t as heavily affected by the pandemic – the gray portion of the stacked bars in Chart 3 – experienced their largest price increases of the year. Those core categories less sensitive to transitory pandemic factors have eased a bit on a year-over-year basis (Chart 4, bottom panel) but the leading month-on-month measure suggests they will turn higher going forward. Chart 3Passing The Baton Watching Both Flanks Watching Both Flanks Shelter costs account for 41% of the core CPI basket and though spiking hotel rates (Chart 5, second panel) have made an outsized contribution to their bounce off the bottom (Chart 5, top panel), the much weightier owners’ equivalent rent and primary residence cost measures have begun to hook up (Chart 5, third panel). Series that impact the supply and demand balance for residences, like the prime-age employment-to-population ratio (Chart 5, fourth panel) and the National Multifamily Housing Council’s measures of apartment market activity (Chart 5, fifth panel), suggest that the key rent series will continue moving higher. Chart 4Transitory Factors Are Abating ... Transitory Factors Are Abating ... Transitory Factors Are Abating ... Chart 5... But Rents Are Rising ... But Rents Are Rising ... But Rents Are Rising The bottom line is that the August CPI report, like much of the economic data in this particularly uncertain time, offered evidence to support opposing interpretations. We will simply have to wait and see how the data evolve over the rest of the year to gain a good read on its future trajectory. We expect that inflation will continue to come down from its summer peak while remaining comfortably above the Fed’s effective 2.3-2.5% core CPI target. Such a move will underscore that its inflation criteria have been met and focus investor attention squarely on the labor market’s progress toward regaining full employment. Much Ado About Nothing The bond market has cottoned on to the fact that the labor market, not consumer price inflation, is the swing factor for monetary policy settings, and the 10-year Treasury note has essentially ignored the core CPI breakout (Chart 6). Equities have evinced little concern, reflecting the causal relationship we noted last week. High inflation by itself is not kryptonite for stocks; the restrictive monetary policy measures the Fed eventually imposes in response to high inflation are. Inflation’s market importance thus turns on the tipping point at which it heralds restrictive monetary policy. Chart 6Treasuries Are On Board With The Transitory View Treasuries Are On Board With The Transitory View Treasuries Are On Board With The Transitory View A Fed that believes elevated inflation readings are transitory is a Fed that will wait to restrain the economy to contain them. A Fed that is determined to let the economy run hot so as to nurture broad-based strength in the labor market is a Fed with a less sensitive inflation reaction function than has prevailed since Paul Volcker’s tenure. The same goes for a Fed that has made no secret of its desire to reset inflation expectations higher. Putting it all together, the Fed appears determined to wait until it sees the whites of inflation’s eyes before it takes action that will undermine economic growth. Our view that the Fed’s inflation reaction function has become less sensitive is independent of the identity of the chair. The revised statement on longer-run goals and monetary policy strategy was issued by the entire FOMC, and investors should not be distracted by the quadrennial reappointment parlor game, which has settled on a contest between chair Powell and board member Brainard. Although Brainard has won progressives’ admiration for her advocacy of tighter bank supervision, policy would not be materially different under her stewardship than it would be under Jay Powell’s. Monetary policy will be accommodative for a long time regardless of who is chairing the FOMC on February 1st and the Biden administration’s nomination decision will not have lasting market implications. Could A Messy Evergrande Unwind Trip Up The US Bull? The financial press last week was filled with stories about the dire condition of Evergrande Property Group (Chart 7), one of China’s largest property developers. As noted in several of last week’s reports, Evergrande is the world’s most indebted developer and its leverage burden is not news to dollar bond investors, who have increasingly required outsized yields to lend to the company.1 All three major credit rating agencies have downgraded it to the equivalent of CC, reflecting their view that default is imminent. Though a technical default may be certain, per reports that Evergrande will fail to make scheduled interest and principal payments due this week, the ultimate ripple effects are unknown. As our Emerging Markets Strategy team has noted, a broad range of outcomes are possible. At the most benign end of the continuum, the event could mark a crescendo of concerns that have been weighing on sentiment and activity, and trigger policy stimulus that produces economic and market inflections. At the other end, Evergrande could intensify the existing credit crunch, sparking a wave of self-reinforcing defaults and bankruptcies, culminating in a systemic event on the order of Lehman Brothers’ bankruptcy. Absent government intervention, the defaults will be messy. Most of the company’s assets are in the form of unfinished properties that will require additional capital and know-how before they can be monetized. Even its portfolios of completed properties may not be easy to sell in a residential market that was already slowing (Chart 8). The pall its troubles have cast over the property market will make things worse by prodding other liquidity-constrained developers to slash prices to move their own inventories. Chart 7Boom And Bust Boom And Bust Boom And Bust Chart 8Not Exactly A Seller's Market Not Exactly A Seller's Market Not Exactly A Seller's Market Our China strategists believe that the government wants to make an example out of Evergrande to impose some discipline on investors and developers. Despite repeated warnings, it has remained on the wrong side of the three red lines policy makers recently established to rein in property market excesses. Some onshore investors may be bailed out, but party officials will have no qualms about leaving offshore investors holding the bag. As China goes, so too do small neighboring economies reliant on its appetite for imports. Resource economies like Brazil, Chile and Australia that export iron ore, copper and other base metals to feed the China construction and infrastructure juggernaut could slow. Suppliers of machinery and specialized manufactured components like Japan and Europe could also feel a bit of a chill. While the US is not immune to disruptions in the rest of the world, it is a comparatively closed economy that is generally less susceptible to external troubles and has minimal financial links with the Middle Kingdom. A review of the 2020 10-Ks for the SIFI banks and Goldman Sachs and Morgan Stanley confirmed that the American banking system has minimal direct exposures to China and Hong Kong. Only Citigroup, which operates a meaningful commercial banking franchise in Hong Kong, has direct cross-border exposures that amount to as much as 1% of assets (Table 1). Table 1SIFI Exposures To China And Hong Kong Watching Both Flanks Watching Both Flanks The bottom line is that we do not view Evergrande as China’s Lehman. Policymakers may want to make an example of it but not to the point that they will stand by in the face of a broad contagion. Even if it did produce a credit event that rippled across Asian EM markets and tempered investors’ enthusiasm for risk assets more generally, US markets would benefit in a relative sense befitting the dollar’s status as a defensive currency, Treasuries’ status as the predominant risk-free asset and the S&P 500’s low-beta nature. The fall of an overextended Chinese property developer is unlikely to push the US out of Goldilocks and into too-cold territory. Investment Implications Inflation will trigger a policy change once it stays high enough for long enough to trigger the Fed’s recalibrated reaction function. Markets will sniff out a policy change ahead of time and could even catalyze a policy change if the bond vigilantes awaken from their long hibernation. When we reiterate our constructive view on markets and the economy over a three-to-twelve-month timeframe, we are reiterating our assessment that markets will not begin to prepare for the policy change within the next twelve months and that growth will appear as if it will remain on an above-trend trajectory for some time beyond. We are confident that the next twelve months will remain “safe” from a policy and a growth perspective. We have much less conviction about the next six to twelve months following next September and are acutely aware that the outlook for the second half of 2022 and the first half of 2023 will exert a meaningful influence next summer. We will adjust our views based on the incoming data, but we do think the first three to six months of our cyclical timeframe will be conducive to risk asset outperformance and therefore reiterate our recommendation to overweight equities and credit while sharply underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Per Evergrande’s annual reports, its average annual interest rate on outstanding debt on 12/31/20 was 9.49%, up from 8.99% on 12/31/19, 8.13% on 12/31/18 and 8.09% on 12/31/17.

Dear Client, I will be holding a webcast next Friday, September 24th at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT) with BCA Research’s Chief Emerging Markets Strategist Arthur Budaghyan where we will debate the outlook for EM stocks. As this week’s report conveys, I am bullish, while Arthur is in the bearish camp. Please join us for what is sure to be a fiery debate. Also, instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the stability of the American political system. I hope you will find it insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2021 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, October 7th. Best regards, Peter Berezin Chief Global Strategist Highlights After lagging the global indices, EM stocks are set to outperform during the remainder of this year and into 2022. Go long the EM FTSE index versus the global benchmark (ETF proxy: VWO versus VT). Five factors will support EM assets over the coming months: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Investors wanting to gain exposure to Chinese tech while still limiting risk should consider writing cash-covered puts. For example, a strategy of selling puts on Alibaba could generate a 9% annualized yield while giving investors access to the stock at a forward PE ratio of only 12.5. Go long an equally-weighted basket consisting of the Russian ruble and Brazilian real against the US dollar. Both currencies enjoy favorable interest rate differentials and will benefit from continued strength in commodity markets. Debating The EM Outlook BCA Research has some of the brightest, most creative strategists in the world. While we often agree on many issues, we sometimes disagree. The near-term outlook for emerging markets is a case in point. My colleague, Chief EM Strategist Arthur Budaghyan, is bearish on emerging markets over a 3-to-6 month horizon. In contrast, I am bullish. In this note, I explain why. I see five reasons why EM assets will do very well during the remainder of the year and into 2022: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Let’s examine all five reasons in turn. Vaccine Access In Emerging Markets Is Improving The proportion of EM populations which have been vaccinated is rising rapidly (Chart 1). India is now vaccinating 10 million people per day, a number that would have seemed unimaginable just a few months ago. Chart 1EM Vaccination Rates Have Been Ramping Up Rapidly The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Globally, about 10 billion doses of vaccine will be produced this year (Chart 2). This does not include potential new mRNA vaccines that China is developing. China-based Walvax Biotechnology is conducting late-stage trials in Nepal, with mass production of the vaccine expected to start in October. Sinopharm is also working on its own mRNA vaccine. Meanwhile, the number of new Covid cases in most EM economies has peaked, permitting a relaxation of lockdown measures (Chart 3). Goldman’s Effective Lockdown Index for China has eased significantly since mid-August, although this week’s outbreak in Fujian province could partially reverse that trend. Chart 2At Least 10 Billion Doses Of Vaccine Will Be Produced This Year The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 3EM Lockdown Measures Have Eased As The Number Of New Cases Has Peaked The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies It is true, as Arthur has pointed out, that vaccine hesitancy is a problem in some emerging markets. However, this may not be as significant an issue as previously believed. The huge spike in cases in highly vaccinated countries such as Israel and the UK shows that herd immunity is a pipe dream. Given this reality, as long as everyone who wants a vaccine is able to receive it, the political pressure to maintain lockdowns will dissipate. Pandemic-Induced Spike In Inflation Is Fading As in most developed economies, many emerging markets have experienced a post-pandemic rise in inflation (Chart 4). Whereas DM central banks generally looked through the inflation spike, many EMs did not have that luxury. Chart 4Inflation Across The EM Universe The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies   Worried about an unmooring of inflation expectations and currency depreciation, central banks in such countries as Brazil, Mexico, Chile, Colombia, Peru, Russia, and Turkey have all raised rates this year. Higher rates have weighed on EM growth and financial markets. The good news is that inflationary pressures are starting to abate. This week’s US CPI report for August showed an absolute decline in prices in pandemic-related categories such as airfares, hotels, admissions, and vehicles (Chart 5). Things are even improving on the semiconductor front. Chart 6 shows that memory chip prices are in a clear downtrend. Chart 5Pandemic-Driven Inflation Is Cresting The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 6Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chart 7Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Critically for emerging markets, agricultural prices have stabilized (Chart 7). Historically, food inflation has been a major driver of EM inflation. Chinese Stimulus On The Way Growth in China was quite weak in the first half of the year, averaging only 3.5% on a sequential annualized basis (Chart 8). The Bloomberg consensus estimate is for Q3 growth to hit 4.3%, reflecting the negative impact of lockdown measures and the lagged effect from policy tightening. Growth in the fourth quarter is expected to rebound to only 5.7%. This seems too low to us. Barring a major spike in Covid cases, Chinese industry will be saddled with fewer social distancing restrictions in the fourth quarter. Policy is also turning more stimulative. The PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 9). Chart 8Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chart 9Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way   With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. On the contrary, the PBOC’s meeting with financial institutions on August 23rd revealed a desire to increase credit availability. Partly reflecting this development, new bank loans rose to RMB 1.22 trillion in August, up from RMB 1.08 trillion in the prior month. Chart 10EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed On the fiscal side, the Ministry of Finance stated on August 27th its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. To reinforce the need for more stimulus, the authorities announced an additional RMB 300 billion in credit support for SMEs during the latest State Council meeting held on September 1st. Local Chinese government spending has typically flowed into infrastructure. Increased infrastructure spending should buttress metals prices while providing a tailwind for global industrial stocks. I agree with Arthur’s assessment that industrials will be a winning equity sector over the coming years. EM stocks have usually beaten the global benchmark during periods when global industrial stocks were outperforming (Chart 10).   A Weaker US Dollar Will Benefit Emerging Markets EM stocks tend to perform best when the US dollar is on the back foot (Chart 11). We expect the greenback to weaken over the next 12 months. As a countercyclical currency, the dollar is likely to struggle in an environment of above-trend global growth (Chart 12). Chart 11EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening Chart 12The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Interest rate differentials have moved sharply against the dollar (Chart 13). The US trade deficit has surged over the past 16 months. The way the US has been financing its trade deficit – relying heavily on fickle equity inflows – also leaves the dollar in a vulnerable position (Chart 14). Chart 13Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Chart 14Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Go Long BRL And RUB Against a backdrop of broad-based dollar weakness, EM currencies will strengthen. Currently, the 12-month interest rate differential between Brazil and the US stands at 8.7%, up from a low of 2.1% last year. Russian rates have also risen rapidly relative to US rates (Chart 15). The Russian ruble will benefit from the cyclical recovery in oil prices. Bob Ryan and BCA’s commodity team project that the price of Brent will rise 5% to $80/bbl in 2023, whereas market expectations are for a 12% decline (Chart 16). Likewise, Brazil will gain from both higher oil prices and rising Chinese demand for metals. Chart 15Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Chart 16Oil Prices Have More Upside Oil Prices Have More Upside Oil Prices Have More Upside Accordingly, we are initiating a new trade going long an equally-weighted basket consisting of BRL/USD and RUB/USD. Are EMs A Value Trap? Emerging market stocks currently trade at a Shiller PE ratio of 14.7, compared to 36.8 for the US, 22.2 for Europe, and 24.1 for Japan. The EM discount to the global index is as large now as it was during the late 1990s. Other valuation measures tell a similar story (Chart 17). Chart 17AEM Equities Are Trading At A Large Discount (I) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 17BEM Equities Are Trading At A Large Discount (II) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies A low PE ratio for EM stocks could be justified based on weak expected earnings growth. However, it is far from clear that such an expectation is warranted. While EM earnings growth has lagged the US since 2011, this follows a decade when EM earnings grew much faster than in the US (Chart 18). Chart 18AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) Chart 18BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) Chart 19EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings On that note, it is worth mentioning that US earnings have risen by only 6 percentage points more than EM earnings since mid 2019 (20% versus 14%), even as EM stocks have underperformed their US peers by 29% over this period (52% versus 23%) (Chart 19). China’s Regulatory Crackdown The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 48% since February (Chart 20). Chart 20Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party just as US companies have pledged allegiance to woke ideology. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 16.4-times earnings, Baidu is trading at 17.9-times earnings, and Tencent is trading at 26.7-times current year earnings. In comparison, the NASDAQ 100 trades at nearly 30-times earnings. Investment Conclusions Sentiment towards EM stocks is very bearish (Chart 21). Investor angst towards China is especially elevated, with the media replete with stories about the tech crackdown and problems at Evergrande, the country’s largest property developer. Chart 21Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish All these downside risks to EM assets are well known. What are less well known are the upside risks stemming from higher vaccination rates, an easing of domestic inflationary pressures, Chinese stimulus, a weaker US dollar, and favorable valuations. With that in mind, we are upgrading our rating on EM equities and currencies to strong overweight in the view matrix at the back of this report. We are also reinstating a long EM/Global equity trade (ETF proxy: VWO versus VT). The risk-reward of buying Chinese internet stocks is reasonably appealing. Investors who want to mitigate risk should consider writing cash-covered puts. For example, a BABA put with a strike price of $130 expiring on December 16th 2022 trades for about $16. If the price of BABA does not fall below $130, you will pocket the premium, realizing an annualized yield of 9%. If the price does fall to $130, you get the stock at an attractive PE ratio of 12.5 based on current forward earnings estimates.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Special Trade Recommendations The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Current MacroQuant Model Scores The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. I will also address the topics that our clients are most concerned about, including China’s regulatory developments, inflation, and policy direction. The webcasts will be held on Wednesday, September 22 at 10:00 am EDT (English), and Thursday, September 23 at 9:00 am HKT (Mandarin). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, September 29. Best regards, Jing Sima, China Strategist Highlights China is facing cyclical inflationary pressures more than disinflationary ones. Prices of mining, raw materials and manufacturing goods have been rising at record rates. Chinese manufacturers are operating at close to full production, which suggests that there is little slack in demand. Despite soft headline readings in consumer prices, the costs of goods and services have rebounded to pre-pandemic levels. Prices for home durable goods, fuel and utilities have surged to multiyear highs. Measures to boost domestic demand will be limited as long as inflationary pressures continue and manufacturers produce at close to full capacity. Near-term policy support will likely focus on reducing costs for manufacturers and improving wage growth for lower-income households. We are initiating a trade: long industrial stocks/short A-shares.  Feature China’s Producer Price index (PPI) registered a 13-year high in August, at the time when the domestic economy continued to slow. On the other hand, consumer prices (CPI) - both headline and core CPI - have been lackluster. The acceleration in producer inflation and the demand dynamics raise the question whether China is in a stagflation, a situation in which prices climb but wages and demand do not follow. Consequentially, economy policy faces a dilemma between boosting demand and containing inflation. Inflationary pressures have been driven by pandemic-related factors and the supply-side constraints will likely continue into Q1 next year. These inflationary pressures, and more importantly, undercurrents in the inflation prints, will constrain Chinese policymakers’ efforts to reflate the economy. The recent rebound in Chinese infrastructure stocks is overdone. Material stocks are also vulnerable to price setbacks. Global commodity prices will soften, although from very elevated levels. Meanwhile, we are initiating a trade: long Chinese industrial stocks relative to the A-share market. Despite falling profit growth in recent months, China’s leadership is increasing its support, both cyclically and structurally, to the manufacturing sector. Inflation Or Deflation? The details in both the PPI and CPI readings indicate that China is facing more inflationary pressures than disinflationary ones. Producers are raising prices across the board. Although consumer prices will likely remain well below the PBoC's 3% inflation target for the year mainly due to low food prices, prices in some of the key consumer goods segments are rising at an alarming pace. The inflationary pressures will continue for producers, at least through the first quarter of 2022. The strength in August’s PPI was concentrated in mining and raw materials (Chart 1, top panel). Robust global demand and tight supply conditions supported high oil and base metals prices, while pushing up coal prices. Chart 1Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chart 2Commodity Prices Held Up Despite A Slowing China Commodity Prices Held Up Despite A Slowing China Commodity Prices Held Up Despite A Slowing China We do not expect China’s infrastructure investment growth to pick up and support industrial metal prices. However, this year’s unsynchronized recovery in global demand and severe supply shortages have delayed the global commodity market’s price reaction to slowing Chinese demand (Chart 2). Moreover, as China’s environmental policy remains stringent during the upcoming winter, supply-side constraints from production cuts will partially offset the slowdown in China’s demand for mining and raw materials (Chart 3A and 3B). Chart 3ASupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Chart 3BSupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Manufacturing goods inflation registered its topmost annual growth since data collection started in 1996 (Chart 1, bottom panel). Moreover, capacity utilization rates in the industrial and manufacturing sectors are at the highest levels since 2007, well above their means (Chart 4). Changes in manufacturing capacity are highly correlated with China’s export growth and tightly linked to PPI (Chart 5). Therefore, manufacturing goods prices will remain lofty as long as external demand stays robust and China’s manufacturers continue to produce near maximum output. Chart 4Chinese Manufacturers Are Producing Near Their Max Capacity Chinese Manufacturers Are Producing Near Their Max Capacity Chinese Manufacturers Are Producing Near Their Max Capacity Chart 5Robust Exports Have Been Supporting Strong Chinese Manufacturing Output Robust Exports Have Been Supporting Strong Chinese Manufacturing Output Robust Exports Have Been Supporting Strong Chinese Manufacturing Output The PPI’s weakest component has been consumer goods, which inched up by a mere 0.3% from a year ago (Chart 6). However, consumer goods only account for 25% of PPI, whereas industrial and manufacturing producer goods are 75%. In addition, the underlying data shows that among the four sub-components in the PPI’s consumer goods, only food prices have remained below their pre-pandemic levels (Chart 7, top panel). Prices in durable goods have rebounded strongly since March last year and clothing and daily sundry articles have recovered to their end-2019 rate of growth (Chart 7, mid and bottom panels).  Chart 6Producer Prices For Consumer Goods Remain Soft... Producer Prices For Consumer Goods Remain Soft... Producer Prices For Consumer Goods Remain Soft... Chart 7...But Food Prices Have Been The Main Drag ...But Food Prices Have Been The Main Drag ...But Food Prices Have Been The Main Drag The PPI’s price forces are consistent with the CPI, in which food has been the main drag. Core CPI, along with prices for consumer goods and services, have returned to pre-pandemic growth rates (Chart 8). Durable goods prices, such as home appliances, increased to a multiyear high in August. Fuel and utilities costs have also risen. This suggests that despite the soft CPI readings, inflation has flowed from producers to Chinese consumers through manufacturing goods. The passthrough will likely intensify into Q4 when domestic COVID-cases have been largely brought under control and the September – October holiday season will boost consumption for both goods and services. Chart 8Prices For Other Consumer Goods Categories Have Recovered Prices For Other Consumer Goods Categories Have Recovered Prices For Other Consumer Goods Categories Have Recovered Table 1A Look At China’s CPI Basket – Food Dominates Inflation, Deflation, Or Stagflation? Inflation, Deflation, Or Stagflation? We still expect that headline CPI will remain below the PBoC’s 3% inflation target for the year. Consumer durable goods prices are lightly weighted in China’s CPI, therefore, an acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates (Table 1). Chart 9Prices For Healthcare And Education Services On A Structural Downshift Prices For Healthcare And Education Services On A Structural Downshift Prices For Healthcare And Education Services On A Structural Downshift In addition, there are some structural headwinds that will affect prices in the education and healthcare and medical services components, which together account for about 15% of the CPI. Healthcare prices have been on a policy-driven structural downshift since late 2017 and recent regulatory changes in the education industry will depress pricing power in that sector (Chart 9). Despite sluggish aggregate consumer prices, climbing prices in consumer durable goods, services and particularly, fuel and utilities, will likely force China’s leadership to take action on policy. Bottom Line: Price pressures for Chinese producers remain intense and consumers will feel the heat of escalating prices in durable goods, fuel and utilities. Inflation is threatening domestic demand, which is already slowing from its peak earlier this year. Implications On Policy Response Inflation readings –even though they are lagging economic indicators –bear significant forward-looking market implications because changes in inflation dynamics herald various policy responses. Despite slower economic growth, higher inflation coupled with accommodative monetary and fiscal policies may indicate that the economy is in a “goldilocks” stage and corporate profits can still benefit (Chart 10). Chinese onshore stocks reached record high recently (Chart 11). Chart 10Are Chinese Corporates In A 'Sweet Spot'? Are Chinese Corporates In A 'Sweet Spot'? Are Chinese Corporates In A 'Sweet Spot'? Chart 11Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 However, underlying trends in China’s producer and consumer inflation prints raise the risks that policymakers may not deliver the ingredients needed for a “just right” scenario. Even though China has kept a loose monetary policy that we expect to extend into next year, inflationary pressures may force policymakers to either delay or reduce the magnitude of stimulus. Recent policy moves show that the authorities are focused on reducing input cost burdens and bumping up support for small- and medium-sized enterprises (SMEs), which are highly concentrated in mid- to downstream manufacturing and services sectors. In our view, the recent rhetoric from policymakers further reduces the odds of any broadly based stimulus to boost demand. Our view is based on the following observations: The elevated global input costs and limited price passthroughs to consumers are depressing Chinese manufacturers’ profit margins and incentives to expand production capacity. Despite strong exports and production, manufacturing investment has lagged that in infrastructure and real estate this year (Chart 12). Consumers, particularly lower-income households, are bearing most of the burdens; rising costs and slow wage growth are weakening their propensity to spend (Chart 13). Chart 12Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Chart 13Slow Wage Growth Limits The Pace Of Consumption Recovery Slow Wage Growth Limits The Pace Of Consumption Recovery Slow Wage Growth Limits The Pace Of Consumption Recovery The inflation prints came at the time when China’s top leadership shifted its structural policy goals to reduce income inequality and stabilize manufacturing share in the aggregate economy. The structural goals will likely be reflected in policy responses to the cyclical challenge.  Moreover, this year’s manufacturing production volume was growing twice as fast as producer prices, a reversal from 2017 when price increases outpaced production (Chart 14). Price changes are much more important to corporate profits than volume changes. A strong RMB and sharply escalating shipping costs have also reduced exporters’ pricing power and profits (Chart 15). In contrast, mounting prices across various commodities have allowed the upstream industrial sectors, which are dominated by SOEs, to deliver much stronger profits than the downstream and private sector (Chart 16). Chart 14Growth In Manufacturing Output And Prices Starting To Converge Growth In Manufacturing Output And Prices Starting To Converge Growth In Manufacturing Output And Prices Starting To Converge Chart 15Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability   It is unsurprising that authorities are increasing support to the private sector in order to maintain manufacturing share in the economy and keep the export sector competitive (Chart 17). A boost in infrastructure investment, on the other hand, would exacerbate upward pressure on commodity prices and mostly benefit upstream SOEs. Chart 16Upstream Industries Disproportionally Benefited From Surging Commodity Prices Upstream Industries Disproportionally Benefited From Surging Commodity Prices Upstream Industries Disproportionally Benefited From Surging Commodity Prices Chart 17Private Sector: Lower Profit Margin, Higher Costs Private Sector: Lower Profit Margin, Higher Costs Private Sector: Lower Profit Margin, Higher Costs Furthermore, stimulating the traditional sectors would not revive household consumption. The subdued recovery in consumption and prices for consumer staple goods is due to slow growth in lower-income household wages and a disrupted recovery in the services sector. Ramping up infrastructure investment can support headline GDP growth, but will do little to provide jobs and wages since China’s private sector provides 80% of all jobs and 90% of annual job creations. Lower-income households have a higher marginal propensity to consume. We expect the government to accelerate fiscal support measures to fortify wages among lower-income households. Bottom Line: Ongoing inflationary pressures and the underlying forces will likely thwart policymakers from stepping up their efforts to stimulate the old economy sectors. Investment Conclusions Chart 18Rebound In Infrastructure Stocks Should Be Short-Lived Rebound In Infrastructure Stocks Should Be Short-Lived Rebound In Infrastructure Stocks Should Be Short-Lived Chinese onshore stocks in the infrastructure, materials, and industrial sectors recently advanced strongly in the expectation that policymakers will ramp up their fiscal support in the old economy sectors, particularly infrastructure. Although we agree that infrastructure investment will improve, we maintain our view that a sizable rebound is highly unlikely this year. Hence, we do not expect that the rally in infrastructure stocks will be long-lasting (Chart 18).  We are probably too late in the cycle to re-initiate our long material/broad market trade in the onshore and offshore equity markets (Chart 19). We closed the trade in December last year when Chinese policymakers started pulling back stimulus, and in expectations that raw material prices would tumble. However, we underestimated the intensity of China’s de-carbonization efforts and protracted global supply-side constraints. Although global commodity prices will remain elevated into 2022, the price rallies from this year are not sustainable on a cyclical (6- to 12-month) basis. Therefore, we do not recommend material stocks as a cyclical play.  Chart 19Price Rally In Materials Stocks Unlikely To Sustain Price Rally In Materials Stocks Unlikely To Sustain Price Rally In Materials Stocks Unlikely To Sustain Chart 20Industrial Stocks May Be On A Structural Upcycle Industrial Stocks May Be On A Structural Upcycle Industrial Stocks May Be On A Structural Upcycle Instead, we recommend a long industrial/broad A-share market trade (Chart 20). Even though China is in a late business cycle and the upcoming stimulus will be mediocre at best, we think that the industrial sector will benefit from policy support for investment in the manufacturing sector and a faster pace in the sector’s capacity expansion.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes Market/Sector Recommendations Cyclical Investment Stance

Highlights Fed: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. We expect Fed rate hikes to start in December 2022 and that the pace of hikes will proceed more quickly than is currently priced in the yield curve. Duration: Investors should maintain below-benchmark portfolio duration in anticipation of a rate hike cycle starting in December 2022. Yield Curve: Investors should position in Treasury curve flatteners. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Feature Chart 1Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 One of our themes this year is that US bond investors should pay more attention to the employment data than the inflation data.1 This is because the Fed has successfully convinced markets that it will not lift rates until “maximum employment” is achieved, even if inflation is strong.2 This story has played out during the past few months as bond yields have remained low despite surging prices (Chart 1). Our view is that the muted reaction in bonds is due to the widespread belief that the labor market remains far from “maximum employment” and that rate hikes are therefore a long way off. In this environment, only surprisingly strong employment prints can upset the market’s narrative and send bond yields higher. This playbook for the bond market will continue to function for the next few months. Strong employment data will pull bond yields higher and disappointing employment data will push them down. Inflation prints will be largely irrelevant for the market. But this will change next year. In fact, we see the employment data taking a back seat to the inflation data in the minds of bond investors in 2022. A More Explicit Definition of “Maximum Employment” Must Emerge In 2022 Almost everyone agrees that the US labor market is far from “maximum employment” today, but that will no longer be the case in 2022. The Appendix to this report shows the average monthly nonfarm payroll growth that is required to reach different possible definitions of “maximum employment” by a few specific future dates. For example, we calculate that average monthly nonfarm payroll growth of 414 thousand would cause the unemployment rate to reach 3.8% and the labor force participation rate to reach 63% by the end of 2022. Our sense is that the US economy will be able to add more than 414 thousand jobs per month between now and December 2022. This means that if Fed officials believe that an unemployment rate of 3.8% and a participation rate of 63% meet the definition of “maximum employment”, then they will start to lift interest rates by then. This example sets the scene for what will become next year’s most important monetary policy debate. What constitutes “maximum employment”? Does our example of a 3.8% unemployment rate and a 63% participation rate meet the definition? Or does the Fed have different targets in mind? The Fed will be forced to clarify its position on the topic as the labor market gets closer to reasonable definitions of “maximum employment”. Our sense is that, as of now, there are a range of views on the committee with some FOMC participants taking a more hawkish view of how much slack is left in the labor market and some adopting a more dovish posture. We outline the differences between the hawkish and dovish positions below, but ultimately the path of inflation in 2022 will determine which camp wins out. If inflation remains high next year, then the Fed will be quicker to declare that the labor market is at “maximum employment”, and vice-versa. The Fed’s reliance on the inflation data to settle the argument of what constitutes “maximum employment” will make inflation the most important economic indicator for bond yields in 2022. Labor Market Slack: The Hawkish Case Chart 2The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The hawkish case for the US labor market reaching “maximum employment” sooner rather than later was outlined nicely last month by our own Bank Credit Analyst.3 First, the Bank Credit Analyst points out that the US labor market was likely beyond “maximum employment” before COVID-19 struck. The implication being that the Fed may move to lift interest rates before the unemployment and participation rates fully recover their pre-pandemic levels. Notice that the unemployment rate (adjusted for the post-COVID surge in people employed but absent from work) was 3.5% in February 2020, well below the Congressional Budget Office’s 4.5% estimate of the natural rate of unemployment (Chart 2).4 Today, the adjusted unemployment rate is 5.5%, not that far above the 3.5%-4.5% range of FOMC participant estimates of the natural rate. If this year’s rate of decline continues, the unemployment rate will hit 4.5% by January 2022 and 3.5% by May 2022. Of course, we know that the Fed takes a broader view of labor market utilization than just the unemployment rate. In particular, we observed sharp declines in labor force participation rates across a wide range of demographic groups when the pandemic struck last year (Chart 3). While the Fed will want to see some improvement in labor force participation, it might be unrealistic to expect the overall labor force participation rate to return to its pre-pandemic level. This is because the aging of the US population imparts a structural downtrend to the participation rate. The dashed line in Chart 4 shows where the participation rate would be if the rate of labor force participation of every individual age cohort remained constant at its February 2020 level. Even in this case, the greater flow of people into the older age groups causes the part rate to fall over time. The message from Chart 4 is that even if the participation rates of every age cohort tracked by the Bureau of Labor Statistics rebound to their February 2020 levels, we would still only expect an overall participation rate of 62.8% by the end of 2022, significantly below the 63.3% seen in February 2020. Chart 3Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Chart 4The Demographic Downtrend In Participation The Demographic Downtrend In Participation The Demographic Downtrend In Participation On top of the demographic argument, we also notice that the pandemic led to a surge in the number of retired people last year, a number that continues to rise quickly (Chart 5). While we should probably expect some increase in the flow of people coming out of retirement to re-join the labor force as the economy recovers, it’s also logical to assume that there will be at least some hysteresis among the retired population. That is, the longer someone is retired, the less likely they are to re-enter the labor force at all. To the extent that the increase in retired people is sticky, it may be ambitious to expect a full convergence of the 55-year+ part rate back to February 2020 levels (Chart 3, bottom panel). All else equal, this will cause the labor market to reach “maximum employment” more quickly than even our demographic trendline for participation suggests. Chart 5A Surge In Retirees A Surge In Retirees A Surge In Retirees The question of how many FOMC participants agree with the above arguments remains open, but our sense is that there are some who will be eager to declare that “maximum employment” has been achieved before we see a full rebound in the unemployment and participation rates back to pre-COVID levels. For example, Fed Vice-Chair Richard Clarida mentioned the “demographic trend” in labor force participation in his most recent speech.5 Also, Dallas Fed President Robert Kaplan said the following in a recent interview: We’ve had 3 million retirements since February 2020. […] Some of these workers will come back into the workforce, but some of these workers are 55 and older and they’re in reasonably good financial shape and COVID has caused them to re-think whether they really want to re-enter the workforce.6 Labor Market Slack: The Dovish Case There are also good arguments on the side of those who think that an appropriate definition of “maximum employment” involves an unemployment rate closer to 3.5% than 4.5% and a participation rate that does return to pre-COVID levels, and maybe even moves higher. First, a study from the Federal Reserve Bank of Kansas City noted that the bulk of the recent increase in the number of retired people is explained, not by an increase in the number of retirements, but by a reduction in the flow of people from retirement back into the workforce (Chart 6).7 This suggests that pandemic-related health risks are the likely culprit behind the increase in the number of retired people, casting doubt on the idea that the increase in retired people will be sticky. Chart 6Increased Retirees: A Closer Look 2022 Will Be All About Inflation 2022 Will Be All About Inflation Second, there is a strong case to be made that even the February 2020 labor force participation rate is not high enough to meet the definition of “maximum employment”. If we look at the participation rates for 25-54 year old men and women, we see that both were in strong uptrends prior to the pandemic (Chart 7), and there is every reason to believe that they would have continued to move higher if COVID hadn’t cut the recovery short. Chart 7Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Consider what some FOMC participants were saying prior to the pandemic: The strong labor market is also encouraging more people in their prime working years – ages 25 to 54 – to rejoin or remain in the labor force, […] So far, we have made up more than half the loss in the Great Recession, which translates to almost 2 million more people in the labor force. But prime age participation could still be higher. - Jerome Powell, November 20198 Whether participation will continue to increase in a tight labor market remains to be seen. But I note that male prime-age participation still remains below levels seen in previous business cycle expansions. - Richard Clarida, November 20199 In a more recent interview, Minneapolis Fed President Neel Kashkari expressed skepticism about the idea that labor force participation is destined to remain in a long-run structural downtrend and said that he’s “not convinced we were actually at maximum employment before the COVID shock hit us.” He also said: Getting [labor force participation] and employment-to-population at least back to where they were before [the pandemic], but not necessarily even declaring victory when we do that. I think that’s a reasonable thing for us to try to achieve.10   Inflation: The Ultimate Argument Settler What the above arguments make clear is that there are good reasons to think that the US labor market will reach some policymakers’ definitions of “maximum employment” perhaps by as early as the middle of next year. However, there are also some policymakers who will adopt a more dovish view of what constitutes “maximum employment”. Ultimately, the path of inflation will determine which camp wins out. This is because the entire concept of “maximum employment” is only meaningful when viewed alongside inflation. If employment is pushed beyond its “maximum”, it definitionally means that labor market tightness is leading to unwanted inflationary pressures. With that in mind, the Fed will increasingly refer to the inflation data next year as it tries to make its definition of “maximum employment” more precise. Crucially, what will matter for the Fed (and for the bond market) is where inflation is next year, not where it is right now. Right now, core inflation is well above the Fed’s price stability target, but it is well known that the recent increase in inflation is concentrated in a few sectors – COVID-impacted services and autos – where prices will decelerate as post-pandemic bottlenecks ease (Chart 8). Just as the Fed ignored surging prices in those sectors this year, it will ignore plunging prices in those sectors next year. What will matter for monetary policy is whether core inflation excluding COVID-impacted services and autos remains contained or rises above levels consistent with the Fed’s target (Chart 8, bottom panel). The Fed will also be inclined to declare that “maximum employment” has been achieved if wage growth is accelerating. Currently, there is some evidence of rising wages but also some major supply bottlenecks in the labor market, as evidenced by the all-time high in job openings (Chart 9). Labor supply constraints should ease next year, but the Fed will be watching closely to see if wage growth moderates in kind or continues to increase. Chart 8Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Chart 9Watch Wages In 2022 Watch Wages In 2022 Watch Wages In 2022 Finally, the Fed will keep a close eye on inflation expectations next year. In particular, it will monitor the Common Inflation Expectations Index and the 5-year/5-year forward TIPS breakeven inflation rate (Chart 10). If either of these indicators break above levels consistent with the Fed’s 2% inflation target, then policymakers will be more inclined to think that “maximum employment” has been attained. Chart 10Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Bottom Line: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. The key indicators to monitor to decide when the Fed will declare that “maximum employment” has been attained are: core inflation excluding COVID-impacted services and autos, wage growth, inflation expectations and the prime-age (25-54) labor force participation rate (Chart 3, panel 2). Investment Implications For bond markets, the question of when the Fed decides that the labor market has reached “maximum employment” is crucial because it will determine the start of the next rate hike cycle. At present, the overnight index swap curve is priced for Fed liftoff in January 2023 and for a total of 78 bps of rate hikes by the end of 2023 (Chart 11). Chart 11Rate Hike Expectations Rate Hike Expectations Rate Hike Expectations Our expectation is that the Fed will start lifting rates in December 2022 and that rate hikes will proceed more quickly than what is currently priced in the market. The unemployment rate will be close to 3.5% by December 2022 and inflation will be sufficiently above the Fed’s target that policymakers will be inclined to view the labor market as at “maximum employment”. Investors should run below-benchmark duration in US bond portfolios to profit from this outcome. We also recommend that investors position for a flatter yield curve by the end of 2022. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Table 1A shows fair value estimates for the 2-year, 5-year and 10-year yields as of the end of 2022 assuming the market moves to price-in the following path for the fed funds rate: The first 25 bps rate hike occurs in December 2022 Rate hikes proceed at a pace of 100 bps per year The fed funds rate levels-off at a terminal rate of 2.08%11 Table 1ATreasury Curve Fair Value Estimates: December 2022 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation In that example, the 2-year and 5-year yields both rise by much more than the 10-year yield and both exceed the change that is priced into the forward curve by more than the 10-year yield. Table 1B shows the results from a similar scenario, the only difference is that the liftoff date is pushed back to March 2023. Both the 2-year and 5-year yields also rise by more than the 10-year yield in this scenario, though the delayed liftoff dampens the relative upside in the 2-year yield. Table 1BTreasury Curve Fair Value Estimates: March 2023 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation Bottom Line: Investors should maintain below-benchmark portfolio duration and position in Treasury curve flatteners in anticipation of a rate hike cycle that will start in December 2022. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +414k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents 2022 Will Be All About Inflation 2022 Will Be All About Inflation Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Watch Employment, Not Inflation”, dated June 15, 2021. 2 Specifically, the Fed’s forward guidance states that it will not lift interest rates until (i) inflation is above 2%, (ii) inflation is expected to remain above 2% for some time and (iii) the labor market has reached “maximum employment”. 3 Please see Bank Credit Analyst Special Report, “The Return To Maximum Employment: It May Be Faster Than You Think”, dated August 26, 2021. 4 For details on the adjustment we make to the unemployment rate please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021. 5 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm 6  https://www.bloomberg.com/news/articles/2021-08-09/dallas-fed-president-rob-kaplan-on-the-economy-and-monetary-policy-right-now?sref=Ij5V3tFi 7 https://www.kansascityfed.org/research/economic-bulletin/what-has-driven-the-recent-increase-in-retirements/ 8 https://www.federalreserve.gov/newsevents/speech/powell20191125a.htm 9 https://www.federalreserve.gov/newsevents/speech/clarida20191114a.htm 10 https://www.bloomberg.com/news/articles/2021-08-16/neel-kashkari-on-the-fed-s-quest-to-get-to-full-employment?srnd=oddlots-podcast&sref=Ij5V3tFi 11 We assume a target range of 2% to 2.25% for the terminal fed funds rate. We also assume that the effective fed funds rate trades 8 bps above the lower-end of its target band, as is presently the case. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns