Inflation/Deflation

Highlights Increasing consumption should be a lot easier than increasing savings. After all, most people like to spend! It is getting them to work that should be challenging. Yet, the conventional wisdom is that deflation is a much tougher problem to overcome than inflation. It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town; fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring onerous financing costs. When the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. The pandemic banished the bond vigilantes. Governments ran massive budget deficits, but bond yields still dropped. While budget deficits will decline from their highs, fiscal policy will remain structurally more accommodative in the post-pandemic period. The combination of easier fiscal policy, increased household net worth, and other factors has raised the neutral rate of interest in the US and most other economies. This means that monetary policy is currently much more stimulative than widely believed. This is good news for equities and other risk assets in the near term, even if it does produce a major hangover down the road. New trade: Short US consumer discretionary stocks relative to other cyclicals. Consumer durable goods spending will slow as services spending and capex continue to recover. A Paradoxical Problem Economic pundits like to say that deflation is a tougher problem to overcome than inflation. We hear this statement so often that we do not think twice about it. In many respects, it is a rather strange perspective. Inflation results from too much spending relative to output, whereas deflation results from too little spending. Yet, people like to spend! One would think it would be much easier to get people to consume than to get them to work. The claim that deflation is a bigger problem than inflation is really just a statement about the limits of monetary policy. If the economy is overheating, central banks can theoretically raise rates as high as they want. In contrast, if the economy is in a deflationary funk, the zero-bound constraint limits how far interest rates can fall. Fortunately, there are other ways of stimulating the economy when interest rates cannot be cut any further. Most notably, governments can utilize fiscal policy by cutting taxes, spending more on goods and services, or increasing transfer payments. Getting Paid To Eat Lunch When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid for eating more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. This sounds so counterintuitive that it is worth thinking through a simple example. Suppose you currently earn $100,000 per year and expect your income to rise by 8% per year. You have $100,000 in debt, which incurs an interest rate of 3%, and want to keep your debt-to-income ratio constant at 100% over time. Next year, your income will be $108,000, so you should target a debt level of $108,000. Thus, this year, you can spend $105,000 on goods and services, make $3,000 in interest payments, and take on $8,000 in additional debt. Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay an additional $6,000 in interest, your cash outflows will exceed your income by $16,000, taking your debt to $216,000 — exactly twice next year’s income. Notice that by maintaining a higher debt balance, you can actually spend $5,000 more while still keeping your debt-to-income ratio constant. Appendix A proves this point mathematically. One might protest that the interest rate you face would be higher if you had more debt. Fair enough, although in our example, the interest rate would need to rise above 5.5% for spending to decline. The more important point is that unlike people, governments which issue debt in their own currencies get to choose whatever interest rate they want. Granted, if central banks set interest rates too low, the economy will overheat, leading to higher inflation. But this just reinforces the point we made at the outset, which is that inflation and not deflation is the real constraint to macroeconomic policy. A Blissful Outcome For Stocks We would not have waded through this theoretical discussion if it did not serve a practical purpose. In April of last year, we wrote a controversial report asking if, paradoxically, the pandemic could turn out to be good for stocks. We noted that by combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards a “blissful outcome” where the economy was operating at full capacity, yet interest rates were lower than they were before (Chart 1). If such a blissful state were reached, earnings would return to their pre-pandemic level, but the discount rate would remain below its pre-pandemic level, thus allowing stock prices to rise above their pre-pandemic peak. In the months following our report, the stock market played out this narrative.   From Blissful To Blissless? Chart 2Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate More recently, bond yields have risen, stoking fears that we are moving towards less auspicious conditions for equities. There is no doubt that many central banks are looking to normalize monetary policy. That said, what central banks regard as normal today is very different from what they thought was normal in the past. Back in 2012, when the Fed began publishing its “dot plot,” the FOMC thought the neutral rate of interest was around 4.25%. Today, it thinks the neutral rate is only 2.5%. And based on the New York Fed’s survey of market participants and primary dealers, investors believe the neutral rate is even lower than the Fed’s estimate (Chart 2). Even if the Fed did not face political pressure to keep interest rates low, it probably would not want to raise them all that much anyway. The same applies to most other central banks. Why The Neutral Rate Is Higher Than The Fed Believes There are at least four reasons to think that the neutral rate of interest is higher than what the Fed believes:   Reason #1: The drag on growth from the household deleveraging cycle is ending As a share of disposable income, US household debt has declined by nearly 40 percentage points since 2008. Debt-servicing costs are now at record low levels (Chart 3). The Fed’s Senior Loan Officer Survey points to an increasing willingness to lend (Chart 4). The Conference Board’s Leading Credit Index also remains in easing territory (Chart 5). Chart 3The Deleveraging Cycle Has Run Its Course Real personal consumption increased by only 1.6% in Q3. However, this was largely driven by a 54% drop in auto spending on the back of the semiconductor shortage. While vehicle purchases normally account for only 4% of consumer spending, the sector still managed to shave 2.4 percentage points off GDP growth in Q3. Chart 4Banks Are Easing Credit Standards Chart 5A Positive Signal For Credit Growth Spending on services rose by 7.9%, an impressive feat considering the quarter saw the peak in the Delta variant wave.   Reason #2: Fiscal policy is likely to remain accommodative in the post-pandemic period The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets (Chart 6). This point has not been lost on governments. While the flow of red ink will abate, the IMF estimates that the US cyclically-adjusted primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits (Chart 7). Chart 8A Record Rise In Household Net Worth Reason #3: Higher asset prices will bolster spending According to the Federal Reserve, US household net worth rose by over 113% of GDP between 2019Q4 and 2021Q2, the largest six-quarter increase on record (Chart 8). Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth, and 2-to-4 cents for every additional dollar of equity wealth. Based on the latest available data, we estimate that US homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption. And this does not even include any spending arising from the $2.4 trillion in incremental bank deposits that households have amassed since the start of the pandemic.    Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Reason #4: Population aging will drain savings Aging populations can affect the neutral rate either by dragging down investment demand or reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 9 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.8% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.5% over the next few decades. The average age of the US capital stock is now the highest on record (Chart 10). Whereas real business fixed investment is 6% below its pre-pandemic trend, core capital goods orders – a leading indicator for capex – are 17% above trend. Capex intentions remain near multi-year highs (Chart 11). All this suggests that investment spending is unlikely to fall much in the future. Chart 10The Average Age Of The US Capital Stock Is Now The Highest On Record Chart 11Capex Intentions Remain At Lofty Levels In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 12). As baby boomers transition from net savers to net dissavers, national savings will fall. UnTaylored  Monetary Policy The Taylor Rule prescribes the Fed to hike rates by between 50-to-100 bps for each percentage point that output rises relative to its potential. Over the past decade, the Fed has favored the higher output gap coefficient, meaning that a permanent one percentage-point increase in aggregate demand should translate, all things equal, into a one percentage-point increase in the neutral rate of interest. Taken at face value, the combination of increased household wealth and looser fiscal policy may have raised the neutral rate in the US by more than five percentage points since the pandemic. This estimate, however, does not consider feedback loops: A higher term structure for interest rates would depress asset prices, thus obviating some of the wealth effect. Higher rates would also reduce the incentive for governments to run large budget deficits. Taking these feedback loops into account, a reasonable estimate is that the neutral rate in the US is about 2% in real terms, or slightly over 4% in nominal terms based on current long-term inflation expectations. This is close to the historic average for real rates, although well above current market pricing. The implication for investors is that US monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting. Higher Inflation Won’t Force The Fed’s Hand… Just Yet When will the Fed be forced to move away from its baby-step approach to monetary policy normalization and adopt a more aggressive stance? Our guess is not for another two years. Last week, we argued that inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps: Most of the recent increase in inflation has been driven by surging durable goods prices (Chart 13). Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation. Chart 13ADurable Goods Spending Has Further To Fall (I) Chart 13BDurable Goods Spending Has Further To Fall (II) In modern service-based economies, structurally high inflation requires rapid wage growth. While US wage growth has picked up recently, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 14). The Fed welcomes this development, given its expanded mandate to pursue “inclusive growth.” At some point in the future, long-term inflation expectations could become unmoored. However, that has not happened yet, whether one looks at market-based or survey-based expectations (Chart 15). Thus, for now, investors should remain constructive on stocks. Chart 14Wages At The Bottom End Of The Income Distribution Are Rising Briskly   New Trade: Short Consumer Discretionary Stocks Relative To Other Cyclicals We continue to favor cyclical stocks over defensives. Within the cyclical category, however, we are cautious on consumer discretionary names. Spending on consumer durable goods still has further to fall in order to return to trend. Durable goods prices will also come down, potentially squeezing profit margins. Go short the Consumer Discretionary Select Sector SPDR Fund (XLY) versus an S&P 500 sector-weighted basket of the Industrial Select Sector SPDR Fund (XLI), the Energy Select Sector SPDR Fund (XLE), and the Materials Select Sector SPDR Fund (XLB). Appendix A Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned about the trebling of the crude oil price since March 2020? Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Treasuries: Bond investors should maintain below-benchmark portfolio duration and continue to short the 5-year note versus a duration-matched 2/10 barbell. For those investors who want to take an outright long position in US Treasuries, the 2-year Treasury note looks like the best security to choose. Municipal Bonds: This week we upgrade our recommended allocation to municipal bonds from overweight (4 out of 5) to maximum overweight (5 out of 5). Investors who can take advantage of the muni tax exemption should favor municipal bonds over Treasuries and over corporate bonds with the same credit rating and duration. In particular, we recommend that investors focus on long-maturity municipal bonds. Fed: Given our view that inflation will fall during the next 12 months, we still view December 2022 as the most likely liftoff date. However, we will continue to monitor our Five Factors For Fed Liftoff to see if our forecast needs to be revised. Feature Our call for a bear-flattening of the US Treasury curve has worked out well during the past few weeks. Long-maturity Treasury yields have almost risen back to their March highs, and the short-end of the curve has also participated in the recent bout of selling (Chart 1). In light of these moves, it makes sense to re-evaluate our nominal Treasury curve positioning. First, we consider whether, at current yield levels, it still makes sense to run below-benchmark portfolio duration. Second, we consider whether our current recommended yield curve trade (short the 5-year note versus a duration-matched 2/10 barbell) remains the best way to extract returns from changes in the yield curve’s shape. The next section of this report answers these questions by looking at forecasted returns for different Treasury maturities across a variety of plausible economic and monetary policy scenarios. Later in the report we look at municipal bond valuation and provide a quick update on last week’s Fedspeak. Forecasting Treasury Returns Three sources of Treasury bond return need to be considered when creating a forecast. Income Return: The return earned from the bond’s coupon payments. Rolldown Return: The return that a bond accrues simply by moving closer to its maturity date in an unchanged yield curve environment. Capital Gains/Losses: The return earned by a bond due to changes in the level and slope of the yield curve. We like to combine the income and rolldown return into one measure called “carry”. The carry can be thought of as the return an investor will earn in a specific bond if the yield curve remains unchanged throughout the investment horizon. Though carry is not the be all and end all of bond returns, it can be illuminating to look at the yield curve in terms of carry instead of the typical yield-to-maturity. Chart 2 shows the usual par coupon yield curve alongside the 12-month carry for each Treasury security. At present, the steepness of the 3-7 year part of the curve means that bonds of those maturities benefit a lot from rolldown. In fact, we see that a 7-year Treasury note will earn more than a 10-year Treasury note during the next 12 months if the curve remains unchanged. After calculating carry, the next step is to calculate capital gains/losses for each bond. To do this, we create some possible scenarios for future changes in the fed funds rate and assume that the yield curve moves to fully price-in that funds rate path over the course of a 12-month investment horizon.1  Next, we calculate the capital gains/losses for each bond based on the new shape of the yield curve in each scenario. Tables 1A-1D show the results from four different scenarios where the Fed starts to lift rates in December 2022. We then assume that the Fed will lift rates at a pace of 75-100 bps per year and that the funds rate will level-off at a terminal rate of either 2.08% or 2.58%. The 2.08% terminal rate corresponds to the median estimate of the long-run neutral fed funds rate from the New York Fed’s Survey of Market Participants. The 2.58% terminal rate corresponds to the median forecast from the Fed’s Summary of Economic Projections.2  The scenario shown in Table 1B is the closest to our base case. In this scenario, some short-maturity bonds deliver positive returns, but returns are negative for the 5-year maturity and beyond. Also, the 5-year note delivers the worst total return of all the maturities we examine. Unsurprisingly, expected returns for the longer maturities drop significantly if we raise our terminal rate assumption to 2.58% (Tables 1C & 1D). Therefore, any call to short the 5-year note versus the long-end relies on an assumption that the market will trade as though the terminal rate is closer to 2% than to 2.5% during the next 12 months. This is in line with our expectation. Finally, we observe that slowing our pace assumption from 100 bps per year to 75 bps raises expected returns across the board, but the 5-year still performs worse than the other maturities (Table 1A). Due to our expectation that inflation will fall during the next 12 months, a December 2022 liftoff remains our base case.3  However, the market has recently moved to price-in an earlier start to rate hikes. As of last Friday’s close, the fed funds futures curve was priced for liftoff in September 2022 and for a total of 49 bps of tightening by the end of 2022 (Chart 3). Chart 3Market Priced For September 2022 Liftoff Tables 2A-2D incorporate these recent market moves into our forecast by looking at the same scenarios as in Tables 1A-1D but assuming a September 2022 liftoff instead of December. The results are not all that different. Expected returns are worse across the board, but the 5-year still looks like the worst spot on the curve unless the market starts to price-in a higher terminal rate. Investment Conclusions Most of the scenarios we examined had negative expected returns for most maturities. We therefore still think it makes sense to keep portfolio duration low. Further, in every scenario the best expected returns can be found in the shorter maturities. In fact, the 2-year Treasury note offers positive returns in every scenario we examined. An outright long position in the 2-year Treasury note looks like a decent trade for investors forced to hold bonds. As for the yield curve, our results suggest that we should continue with our current positioning: short the 5-year note versus a duration-matched 2/10 barbell. The 5-year note performs worst in every scenario that assumes a 2.08% terminal rate. While it’s conceivable that investors will eventually push their terminal rate expectations higher, we think this is more likely to occur once the Fed has already lifted rates a few times. Bottom Line: Bond investors should maintain below-benchmark portfolio duration and continue to short the 5-year note versus a duration-matched 2/10 barbell. For those investors who want to take an outright long position in US Treasuries, the 2-year Treasury note looks like the best security to choose. The Duration Drift In Municipal Bond Valuations One under-discussed aspect of municipal bonds is that the securities tend to pay higher coupons than other bonds. That is, the bonds will often be issued with coupon rates well above prevailing yields. Investors therefore must pay a higher price to purchase the bonds, but they receive more return in the form of coupon payments. This feature of municipal bonds has important implications for how we should value them. For example, while the average maturity of the Municipal Bond index is much higher than the average maturity of the Treasury index, the muni index’s higher coupon rate makes its average duration significantly lower (Chart 4). This means that any valuation measure that compares a municipal bond’s yield with the yield of another bond with the same maturity will be unflattering for the muni. Chart 4Munis Pay High Coupons, Have Low Durations Further, since Treasury securities and corporate bonds tend to issue at par, the coupon rates paid by those securities have fallen alongside yields during the past few decades. Meanwhile, municipal bond coupons have been relatively stable (Chart 4, panel 3). This means that, over time, municipal bond durations have fallen significantly compared to the durations of other US bond sectors. A fair valuation measure would compare municipal bond yields with equivalent-duration Treasury yields and that is exactly what we’ve done. Chart 5A shows the spread between General Obligation (GO) muni bond yields and equivalent-duration Treasury yields. Chart 5B shows the spreads expressed as percentile ranks. For example, a percentile rank of 50% means that the spread is at its historical median, a percentile rank of 10% means the spread has only been tighter 10% of the time. Chart 5AGO Muni/Treasury Spreads I Chart 5BGO Muni/Treasury Spreads II The first thing that jumps out from our analysis is that municipal bonds are not that expensive. Shorter-maturity spreads were tighter than current levels as recently as 2019/20 and the long-maturity (17-year+) spread is positive, despite the muni tax exemption. In terms of percentile rank, spreads for all GO maturity buckets are only just below the historical median. However, spreads traded much tighter prior to the 2008 financial crisis and it may not be reasonable to expect munis to return to those tight mid-2000 valuations. Charts 6A and 6B repeat the exercise from Charts 5A and 5B but for Revenue bonds instead of GOs. The message is similar. Muni valuations are not that stretched compared to history, and investors can earn a before-tax spread pick-up in munis versus Treasuries if they focus on the long maturities. Chart 6ARevenue Muni/Treasury Spreads I Chart 6BRevenue Muni/Treasury Spreads II In fact, municipal bonds offer a before-tax yield advantage versus Treasuries for Revenue bonds beyond the 12-year maturity point and for GO bonds beyond the 17-year maturity point. Further, the breakeven tax rate for 12-17 year GOs versus Treasuries is a mere 1% and the breakeven tax rate for 8-12 year Revenue bonds is only 8%. Investors facing a tax rate above the breakeven rate will earn an after-tax yield pick-up in munis versus duration-matched Treasuries (Table 3). Table 3Muni/Treasury And Muni/Credit Yield Ratios Of course, municipal bonds also carry a small credit risk premium relative to duration-matched Treasuries. The GO and Revenue indexes have average credit ratings of Aa1/Aa2 and Aa3/A1, respectively, compared to a Aaa rating for US Treasuries. But we can control for credit risk as well by comparing municipal bonds to the US Credit Index and matching both the duration and credit rating. Even this comparison looks favorable for municipal bonds. Once again, long-maturity munis offer a before-tax yield advantage compared to credit rating and duration-matched US Credit. Meanwhile, breakeven tax rates for other maturities are low enough to attract most investors. Bottom Line: This week we upgrade our recommended allocation to municipal bonds from overweight (4 out of 5) to maximum overweight (5 out of 5). Investors who can take advantage of the muni tax exemption should favor municipal bonds over Treasuries and over corporate bonds with the same credit rating and duration. In particular, we recommend that investors focus on long-maturity municipal bonds, noting that the relatively low duration of these bonds makes them attractive relative to other bonds with similar risk profiles. Five Fed Factors A lot of Fedspeak hit the tape last week. Of particular interest were an interview with Chair Jay Powell on Friday and speeches by Fed Governors Randy Quarles and Chris Waller on Wednesday and Tuesday. One takeaway from their remarks is that a tapering announcement at the next FOMC meeting is very likely, with net asset purchases expected to hit zero by the middle of next year. The market, however, seems to have already taken the taper announcement on board. The more interesting aspects of the speeches were the discussions about how the Fed will decide when to lift rates and how elevated inflation readings may or may not influence that decision. We’ve noted in prior reports that five factors will determine when the Fed finally decides to lift rates, and last week’s comments gave us confidence that we’re on the right track. We run through our Five Factors For Fed Liftoff below, with some additional comments on why each factor is important (Table 4). Table 4Five Factors For Fed Liftoff 1. The Unemployment Rate The Fed has officially pledged through its forward guidance not to lift rates until “maximum employment” is reached. While the exact definition of “maximum employment” can be debated, there is widespread agreement that it includes an unemployment rate below its current adjusted level of 4.9%.4 More specifically, we inferred from the September Summary of Economic Projections that most FOMC participants view an unemployment rate of around 3.8% as consistent with “maximum employment” (Chart 7).5 Chart 7Defining "Maximum Employment" We expect that the Fed will refrain from lifting rates until the unemployment rate reaches 3.8%. 2. Labor Force Participation We explored the debate about labor force participation in a recent report.6 In short, there are some policymakers who believe that “maximum employment” cannot be achieved until the labor force participation rate has returned to pre-COVID levels. There are others, however, who think that an aging population and the recent uptick in retirements make such a return impossible. Randy Quarles, for example: I expect that as conditions normalize, [the labor force participation rate] will pick up, but it is unlikely to return to its February 2020 level. One reason is that a disproportionate number of older workers responded to the initial shock of the COVID event by retiring, which may be an area where participation and employment struggle to retrace lost ground.7 In his speech, Governor Waller also mentioned “2 million jobs” that will be lost forever due to retirements.8 While many policymakers cite increased retirements as a reason why the overall labor force participation rate will remain permanently lower, there is much broader agreement that a reasonable definition of “maximum employment” should include the prime-age (25-54) labor force participation rate being much closer to its February 2020 level (Chart 7, bottom panel). We think the Fed will refrain from lifting rates until the prime-age (25-54) labor force participation rate is close to its February 2020 level. 3.  Wage Growth Accelerating wages are a tried-and-true signal that the labor market is running hot. While wage growth is rising quickly right now (Chart 8), there is a strong sense that this is due to pandemic-related labor supply shortages and that wage growth will moderate as pandemic fears (and labor shortages) wane. Chart 8Wage Growth What will be more important is what wage growth looks like when the unemployment rate is close to the Fed’s target of 3.8%. At that point, accelerating wages will give the Fed a strong signal that a 3.8% unemployment rate really does constitute “maximum employment”. 4.  Non-Transitory Inflation Of our five factors, this is admittedly the most difficult to pin down. However, Governor Quarles did a good job of explaining non-transitory inflation in last week’s speech: The fundamental dilemma that we face at the Fed now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation. But the fundamental productive capacity of our economy as it existed just before COVID – and, thus, the ability to satisfy that demand without inflation – remains largely as it was, constraining demand now, to bring it into line with a transiently interrupted supply, would be premature. Essentially, Quarles is saying that the Fed does not want to respond to a pandemic-related supply shock by lifting rates and curtailing aggregate demand. The Fed only wants to tighten policy if it sees an increase in broad-based inflationary pressures that will not be contained naturally by a return to more normal aggregate supply conditions. Accelerating wages would be one signal of such broad-based inflationary pressures, as would be measures of core inflation excluding those sectors that have been most impacted by the pandemic supply disruptions (Chart 9). Lastly, we could also look at indicators of inflation’s breadth across its different components, which have recently spiked to concerning levels (Chart 10). Chart 9Non-Covid Inflation Chart 10CPI Breadth Has Spiked 5.  Inflation Expectations Inflation expectations are also critical to monitor. While all Fed participants seem to agree that inflation will fall during the next year, there is also widespread agreement that if high inflation causes inflation expectations to rise to uncomfortably high levels, then the Fed will be forced to act. Chris Waller: A critical aspect of our new framework is to allow inflation to run above our 2 percent target (so that it averages 2 percent), but we should do this only if inflation expectations are consistent with our 2 percent target. If inflation expectations become unanchored, the credibility of our inflation target is at risk, and we likely would need to take action to re-anchor expectations at our 2 percent target. At present, inflation expectations remain well-anchored near levels consistent with the Fed’s target (Chart 11). In particular, we like to track the 5-year/5-year forward TIPS breakeven inflation rate targeting a range of 2.3% to 2.5% as consistent with the Fed’s target. Incidentally, Governor Waller also flagged TIPS breakeven inflation rates as his “preferred” measure of inflation expectations in last week’s speech.  Chart 11Inflation Expectations Remain Well-Anchored The Fed will move much more quickly toward rate hikes if the 5-year/5-year forward TIPS breakeven inflation rate moves above 2.5%. Bottom Line: Given our view that inflation will fall during the next 12 months, we still view December 2022 as the most likely liftoff date. However, we will continue to monitor our Five Factors For Fed Liftoff to see if our forecast needs to be revised.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 All of our scenarios use a 12-month investment horizon and assume a term premium of 0 bps. 2 In both cases we assume that the fed funds rate trades 8 bps above its lower-bound, as is currently the case. 3 Please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. 4 We adjust the unemployment rate for distortions in the number of people employed but absent from work. Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 for further details. 5 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 6 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 7 https://www.federalreserve.gov/newsevents/speech/quarles20211020a.htm 8 https://www.federalreserve.gov/newsevents/speech/waller20211019a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. Goods inflation will ease in 2022, while energy price pressures will abate. This suggests that we are currently near the top of those two steps. Any decline in inflation will be short-lived, however. Tight labor markets will bolster wages. Rent inflation is also poised to pick up, especially in the US. The Fed and other central banks will face political pressure to keep interest rates low in order to suppress debt-servicing costs. This could lead to overheating. While we are not as bullish on stocks as we were at the start of the year, the combination of low interest rates and above-trend growth over the next 12 months will support equities. Investors should favor cyclicals, value stocks, small caps, and non-US markets. The Stairway To Higher Inflation In past reports, we argued that global inflation had reached a secular bottom and would begin to reaccelerate (see here, here, and more recently here). While it is still too early to be certain, recent developments appear to have vindicated that view. The path to structurally higher inflation is likely to be a bumpy one. We have generally contended that the shift to a more inflationary regime would follow a “two steps up, one step down” pattern, characterized by a series of higher highs and higher lows for inflation. In thinking about the inflation process, it is useful to distinguish between transitory shocks and structural forces. Unfortunately, much of the recent discussion about inflation has been politically charged, with one camp arguing that high inflation is entirely transitory (mainly due to pandemic disruptions) and another camp arguing that it is entirely structural in nature (big budget deficits, QE, and “dollar debasement” are often cited). The idea that both transitory shocks and structural forces may be driving inflation seems to generate a lot of cognitive dissonance in peoples’ minds. Our view is that transitory shocks have pushed up inflation, but that structural forces (both policy and non-policy related) are playing an important role too. In other words, we think that we are near the top of those metaphorical two steps. The next step for inflation is likely down, even though the longer-term trend is to the upside. Team Transitory Is Right About One Thing During most recessions, cyclically-sensitive durable goods spending falls, while the service sector serves as a ballast for the economy. The pandemic flipped this pattern on its head (Chart 1). While durable goods spending did dip briefly, it came roaring back due to generous stimulus payments and stay-at-home restrictions which cut many households off from the services they normally purchase. In March of this year, US real consumer durable spending was 27% above its pre-pandemic trend (Chart 2A and 2B). Chart 1Unlike During Most Recessions, Durable Goods Spending Spiked Due To Stimulus Checks And Stay-At-Home Restrictions Chart 2ADurable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (I) Chart 2BDurable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (II)     Durable goods spending has retreated since then, however. As of August, it was only 8% above its trendline. Supply-chain bottlenecks have curbed durable goods spending over the past eight months. A tell-tale sign of a supply shock is when spending declines and prices nonetheless rise. Between January 2020 and March 2021, durable goods spending increased at an annualized rate of 29% while prices rose at an annualized pace of 2%. Since March 2021, durable goods spending has fallen at an annualized pace of 28%, but price inflation has accelerated to 15% (Chart 3). Even more than other categories of durable goods, vehicle production has been stymied by supply-chain disruptions. Motor vehicles and auto parts represent about 40% of the durable goods sold in the US and accounted for nearly two-thirds of the decline in real durable goods spending between March and August. The downward trend in vehicle sales continued in September, with unit sales declining by 7.2% on the month. In the US, vehicle sales are now back to where they were in 2011 when the unemployment rate was 9%. In the euro area, they are below their sovereign debt crisis lows (Chart 4). The chip shortage hampering vehicle production will abate in 2022. However, vehicle prices are likely to come down only slowly. Auto inventories in the US are only a third of what they were prior to the pandemic (Chart 5). Until dealers are able to rebuild inventories, they will have little incentive to cut prices. Chart 4The Chip Shortage Has Caused Auto Sales To Tumble Chart 5Dealer Inventories Have Collapsed   Energy Price Pressures Should Abate, But Probably Not As Fast As Investors Expect Investors believe the recent surge in energy prices will reverse. The futures curves for oil, natural gas, and coal are all in steep backwardation (Chart 6). We agree that energy price pressures are likely to abate in 2022. However, as we discussed last week, the odds are that prices do not fall as quickly as anticipated. This concern is especially acute in Europe, where La Niña could lead to another cold winter and uncertainty abounds over the status of the Nord Stream 2 pipeline. Looking beyond the next 12 months, the risk is that years of declining investment in the oil and gas sector lead to continued energy shortages during the remainder of the decade. In 2020, 12% of global energy production came from renewable sources such as solar, wind, and hydro. The IEA estimates that this share will rise to 20% in 2030. However, the IEA also reckons that the global economy will still need about 5% more oil and natural gas than it consumes now (Table 1). Given the reluctance of many countries to invest in nuclear power generation, the phase-out of carbon-based fuels may take longer than expected. Table 1Oil And Gas Consumption Will Not Peak Until The Next Decade   Near-Term Upside For Rents Despite increasing home prices in most economies, rent inflation decelerated in the first year of the pandemic (Chart 7). More recently, however, the rental market has begun to heat up. US rents rose by 0.5% in September, the fastest monthly growth since the 2006 housing boom (Chart 8). The Zillow rent index, which looks only at units turning over, has spiked (Chart 9). Chart 7Rent Inflation Is Bouncing Back After Falling During The Pandemic Chart 8More Upside To Rent Inflation   Strong job growth, the end of the nationwide eviction moratorium, and the loosening of regulations freezing rents in a number of US cities and states are all contributing to higher rent inflation. A shortage of homes is also putting upward pressure on home prices and rents. After having surged during the Great Recession, the homeowner vacancy rate has fallen to record low levels (Chart 10). Chart 9Newly Listed Apartments Are Being Marked Up Sharply Chart 10The Home Vacancy Rate Is Very Low In addition to encouraging more construction, higher home prices could indirectly boost inflation through the wealth effect. According to the Federal Reserve, homeowner equity increased by $4.1 trillion, or 21%, between 2019Q4 and 2021Q2. Empirical estimates of the wealth effect suggest that consumption rises between 5 and 8 cents for every additional dollar in housing wealth. For the US, this would translate into 0.9%-to-1.4% of GDP in incremental annual consumption since the start of the pandemic. Higher Nominal Income Growth Would Make Housing More Affordable Chart 11Many Developed Economies Feature Overheated Housing Markets The housing wealth effect would turn negative if home prices were to fall. While this is less of a risk in the US where housing is still reasonably affordable in many states, it is more of a risk in countries such as Canada, Australia, New Zealand, and Sweden where home prices have reached stratospheric levels in relation to incomes and rents (Chart 11). Not only would a decline in nominal home prices curb construction and consumer spending, but it would also potentially undermine the financial system by reducing the value of the collateral backing mortgage loans. To support spending and preclude an outright fall in home prices, central banks would likely keep interest rates at fairly low levels. Low rates, in turn, would incentivize governments to maintain accommodative fiscal policies. The IMF expects the cyclically-adjusted primary budget deficit to be 2% of GDP larger in advanced economies in 2022-26 compared to 2014-19 (Chart 12). The combination of low interest rates and loose fiscal policies will help drive nominal income growth, thus allowing for improved home affordability without the need for a disruptive decline in home prices. As Japan’s experience demonstrates, a deflationary environment is toxic for the property market and the financial system. Labor Markets Getting Tighter There is little doubt that the US labor market is heating up. Even though there are 5 million fewer people employed now than at the start of the pandemic, the job vacancy rate is near record high levels and workers are displaying few misgivings about quitting their jobs (Chart 13). Part of the apparent tightness in the US labor market stems from pandemic-related factors. Although enhanced federal unemployment benefits have expired, households are still sitting on $2.4 trillion in excess savings (Chart 14). This cash cushion has allowed workers to be choosy in entertaining job offers. In addition, decreased immigration flows and a spate of early retirements have decreased labor supply. More recently, the introduction of vaccine mandates has caused some disruptions to the labor market. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Although many of them will reconsider, the anecdotal evidence suggests that some will not. In one glaring example, 4.6% of workers resigned from a rural hospital in upstate New York, causing the maternity ward to temporarily suspend operations. Prospects For A Wage-Price Spiral Chart 15Wages At The Bottom End Of The Income Distribution Are Rising Briskly So far, much of the pick-up in wage growth has been confined to the bottom end of the income distribution (Chart 15). Wage pressures are likely to become more broad-based over time as the unemployment rate continues to decline. A full-blown wage-price spiral would worry the Fed. However, such a spiral does not appear imminent. While respondents to the University of Michigan survey in October expected inflation to reach 4.8% over the next 12 months, they anticipated inflation of only 2.8% over a 5-to-10-year horizon (Chart 16). This is not much higher than their pre-pandemic expectations and is lower than the 3.0% figure reported for September. Chart 16Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels It is easy to dismiss households’ beliefs about future inflation as being largely irrelevant. However, these beliefs do influence spending decisions. For example, a record share of households say that this is a bad time to buy a car (Chart 17). The top reason given is that prices are too high. In other words, many households are deferring the purchase of a vehicle in the hopes of getting a better deal. Automobile demand would be a lot higher now if households thought that prices would keep rising, as this would incentivize them to buy a car before prices rose even more. Chart 17Households Think That This Is The Worst Time Ever To Buy A Car Chart 18Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s What should be acknowledged is that inflation expectations tend to be governed by complex social feedback loops, which makes the relationship between slack and inflation highly non-linear. The experience of the 1960s provides a pertinent example. The US unemployment rate reached NAIRU in 1962. However, it was not until 1966, when the unemployment rate was two percentage points below NAIRU, that inflation expectations became unhinged. Within the span of ten months, both wage growth and CPI inflation doubled, with the latter reaching 6% by the end of the decade (Chart 18). The lesson is clear: While long-term inflation expectations are well anchored today, there is no guarantee they will stay that way indefinitely. Is this a lesson that the Fed will heed? Like Larry Summers, we have our doubts, suggesting that the long-term risks to inflation are to the upside. Fighting The Last War Just as military generals are prone to fighting the last war, the same is true of economic policymakers. Central bankers have been staring down the barrel of the deflationary gun for over two decades. In the 1960s, policymakers prioritized high employment over low inflation. With memories of the Great Depression still fresh in their minds, they kept policy rates too low for too long. This time around, policymakers have an additional reason to drag their heels in raising rates: government debt is very high. Higher borrowing costs would force governments to shift spending from social programs to pay off bondholders. Needless to say, that would not be very popular with most voters. Reducing debt-to-GDP ratios via higher nominal income growth will prove to be more politically palatable than fiscal austerity. Investment Conclusions The path to high interest rates is lined with low interest rates. Structurally higher inflation will eventually lead to higher nominal interest rates, but not before an extended period of negative real rates. Chart 19Neither The Fed Nor The Markets Think The Neutral Rate Of Interest Is All That High Neither the Fed nor the markets think the neutral rate of interest is all that high (Chart 19). We think the neutral rate is higher than widely believed. However, this will not become apparent until the unemployment rate falls well below its full employment level. For now, the Fed’s leadership will want to avoid rocking the boat by turning more hawkish. While the US 10-year Treasury yield will trend higher over time, it will pause at around 1.8% in the first half of next year as the unwinding of pandemic-related bottlenecks leads to a “one step down” for inflation. The ECB and the Bank of Japan are even more reluctant to tighten monetary policy than the Fed. Some developed economy central banks like those of the UK, Norway, Sweden, Canada, and New Zealand are more inclined to normalize monetary conditions. That said, they too will be constrained by the fear that going it alone in raising rates will put undue upward pressure on their currencies. While we are not as bullish on stocks as we were at the start of the year, the combination of low interest rates and above-trend growth over the next 12 months will support equities. As we discussed in our recent strategy outlook, investors should favor cyclicals, value stocks, small caps, and non-US markets. Bitcoin Trade Update After being up as much as 50%, our short Bitcoin trade got stopped out for a loss. We remain bearish on Bitcoin and have decided to reinstate the trade.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Liquidity conditions in Bangladesh are easy and growth has revived. Exports are set to recover as well. Foreign reserve accumulation will continue, which will have positive implications for the economy and stock prices. Steadily rising capital expenditure has improved the economy’s productivity and competitiveness. Progress towards gender and income equality has also been impressive. Growth will stay strong and steady, which warrants higher equity multiples. Bangladeshi stocks also have low correlation with their EM and Emerging Asian counterparts, providing diversification benefits. Absolute return investors should buy this market on dips. Dedicated EM/Frontier market equity portfolios should consider overweighting Bangladeshi stocks. Feature A new business cycle appears to be unfolding in Bangladesh. Domestic demand has picked up. Exports are slated to rise as well. The country’s structural progress also continues to be impressive. Not surprisingly, stocks have gone up in tandem. Yet, high and rising oil prices may lead to a pause in the rally. Absolute-return investors with a time horizon of more than one year should therefore consider accumulating equities on dips. Dedicated equity investors should consider adding the very ‘low-correlation’ Bangladeshi equity market to an EM Asia/EM equity portfolio (Chart 1).   External Tailwinds Bangladesh’s foreign reserves have surged to a new high. This has been a very positive development for both the economy and stock prices (Chart 2). Chart 1Bangladeshi Stocks Will Benefit From Liquidity Tailwinds Chart 2Foreign Reserves, M1 And Stock Prices Chart 3Both Current And Capital Account Balances Have Improved The country’s balance of payments (BoP) has improved substantially in the last couple of years. The improvement can be attributed to both current and capital accounts: The current account deficit has narrowed significantly since 2018. The improvement will likely persist as the outlook of its two main components are both promising: Remittances have surged to an all-time high of $25 billion over the past 12-months. In the coming year too, it will likely stay buoyant thanks to a 2% incentive scheme that the government introduced on inward remittances (Chart 3, top panel). The second major component, the trade deficit, will likely stabilize. This is because exports are set to pick up, in part due to rising orders from the EU, Bangladesh’s prime export destination (Chart 4). The recent surge in trade credit inflows also implies a significant rise in export revenues in the coming months (Chart 5). That said, high oil prices, if they remain as such, will lead to higher import bills. Crude and petroproducts make up about 10% of Bangladesh’s import costs and can be a headwind to the trade balance, and by extension, stock prices. Chart 6 shows that stock prices accelerate when oil prices are low, but struggle when oil prices rise. Chart 4Strong EU Orders Means Exports Are Set To Accelerate Further Chart 5A Surge In Trade Credit Also Implies Strong Export Numbers Ahead   Capital account inflows have risen sharply too. The rise is due mainly to surging trade financing inflows (as mentioned above), and elevated government foreign borrowing (Chart 3, bottom panel). Going forward, trade financing inflows can remain at a high level if the country continues to obtain the same volume of export orders. The government’s foreign borrowing may also persist. Notably, this long-term financing is mostly used to import capital goods – something that the country needs for its investment and infrastructure projects (Chart 7). With Bangladesh’s ever-rising capital expenditure, such long-term capital inflows – either in the form of government borrowing, or FDI, or a combination of two – will likely continue. If so, this will not only help boost the country’s BoP in the short-term, but it will also be a long-term positive for Bangladesh since capital spending will help improve productivity. Chart 6Stocks Struggle Whenever Oil Prices Rise Too Much Chart 7Government's Foreign Borrowings Help Finance Infrastructure Projects   Overall, odds are that the BoP will stay in healthy surplus, thus allowing the central bank continue to accumulate foreign exchange reserves. This has major ramifications for the domestic economy. Rising foreign reserves augment domestic money supply. Stronger money supply is bullish for the economy, and in turn, stock prices (Chart 2, above).   Growth Has Revived Domestic demand has revived. Manufacturing has risen to well-above pre-pandemic levels. Robust economic activity is also vouched for by strong electricity generation (Chart 8). What’s more, the recovery will likely have legs as a new credit cycle could well be unfolding. For one, banks are flush with excess reserves – usually a precursor to rising credit going forward. This is because the Bangladeshi central bank uses excess reserves to achieve its monetary policy objectives1 (Chart 9). Chart 8Bangladesh's Domestic Growth Has Revived Well Beyond Pre-Pandemic Levels Chart 9A Deluge Of Excess Reserves Will Help Kickstart A New Credit Cycle Chart 10Banks' NPL Problems Have Abated Marginally Incidentally, the central bank is planning to engineer an acceleration in its domestic credit growth rate to 17.8% by June 2022, up from 10.3% in June 2021. It is also planning to augment the broad money growth to 15% from 13.6% in June 2021 as part of its 2021-22 policy objectives. That means the monetary policy setting will remain very accommodating in the foreseeable future, paving the way for a new credit cycle. Notably, the country’s inflation is under control, with both headline and core CPI hovering around 5 - 6% over the past few years. Wage growth has also been broadly in line with consumer inflation and shows no sign of accelerating. Contained wages and consumer price inflation will make the central bank’s plan to run easy policy more feasible.  Meanwhile, the banks’ bad loan problems have abated somewhat. As per the latest data from the IMF, the banking system’s gross NPL ratio has fallen to 8.1%, and its net NPL ratio to 4.6% as of Q1 this year (Chart 10, top panel). The lingering NPLs are concentrated in a handful of state-owned banks whose role in the economy has steadily diminished and which now hold about 20% of the banking sector loans. Banks' capital adequacy ratios are also decent at 11.6% and 7.8% (for Tier I capital) respectively (Chart 10, bottom panel). Hence, banks will likely be more willing to expand their loan books going forward which should help propel economy. Chart 11Bangladesh Has Notched Up Impressive Growth Without Any Credit Gush Remarkably, over the past decade, Bangladesh has been able to notch up a robust growth rate of 7%+ without any credit gush in the economy. Domestic credit, at 48% of GDP, is at the same level as it was ten years ago (Chart 11). Hence, should a new credit cycle unfold, Bangladeshi’s growth rate will likely move up a notch higher than it has been in the recent past. The country’s fiscal stance is not going to be tight either. The parliament has passed a budget for the 2021-22 fiscal year (July – June) that envisages a nominal spending growth of 6.3%. Incidentally, government debt is rather low at 23% of GDP. Including the debt held by all the public corporations (concentrated in public financial corporations), gross public debt goes up to 56% of GDP - still a manageable figure.  Real government borrowing costs are low as well. The 10-year nominal bond yield is at 6%; in real terms (deflated by non-food CPI), it is 0%. Thus, fiscal authorities have the wherewithal to ramp up borrowing and spending to stimulate the economy should there be a need. Robust Structural Backdrop Structurally, the Bangladeshi economy is remarkably resilient. The growth rate has not only been very steady but has also seen acceleration over the past quarter century. This is in sharp contrast to the boom-and-bust cycles experienced in most other developing nations (Chart 12). Even during the recent pandemic, Bangladesh has been one of the rare countries where growth has remained positive. Importantly, factors behind this stable growth are likely to persist: Bangladesh has done very well to ramp up its capital expenditure to a substantial 32% of GDP, one of the highest rates globally (Chart 13, top panel). This has helped the economy gain competitiveness over time – which is evident in the continued improvement in its net exports volume (Chart 13, bottom panel). Chart 12Bangladeshi Economy Has Been Devoid Of Boom-Bust Cycles Chart 13Strong And Rising Capex Has Led To Higher Competitiveness   Strong capex has also been instrumental for the economy to grow at a very robust 6-7% rate for decades at a stretch and yet keep inflation under control. This indicates that productive capacity and labor productivity have been rising. Inflation is often a binding constraint to fast growth over a prolonged period of time. Bangladesh’s productivity growth rates have indeed risen to among the highest rates globally, the pandemic-hit last year being a deviation from the long-term trend (Chart 14). What’s more, given the sustained investment in productive capacity and the still low absolute level of labor productivity – compared to other East and South-east Asian economies – Bangladesh should continue to see robust productivity gains in the foreseeable future. Bangladesh specializes in a staple consumer product: textiles. Rising productivity has helped export volumes quintuple over the past two decades; handily beating both emerging markets and global exports volume growth. Incidentally, in common currency terms, the relative wage ratio between Bangladesh and China has been flat at a low level. This has helped Bangladesh remain competitive and continue to expand its global export market share (Chart 15). Chart 14Bangladesh's Productivity Growth Rate Is Among The Best Globally Chart 15Bangladesh Has Been Consistently Gaining Market Share In Global Trade   The country’s demographic outlook is also positive. The working age population as a share of the total is projected to rise for another decade.2 Together, strong productivity growth and a rising labor force will ensure an enviable potential growth rate of around 7 - 8% over the next decade. Inclusive, Sustainable Growth Economic factors aside, strong and steady growth in Bangladesh also owes much of its achievements to social progress. Over the past few decades, the country has attained significant improvements in various human development areas: Bangladesh boasts of one of the highest female participation rates in its labor force in the Muslim world. At 36%, this is almost twice as high as the Middle East & North Africa (20%), Pakistan (22%), and neighboring India (21%) – as per the World Bank. In the fledgling textile industry in Bangladesh, over 75% of workers are women. The country pioneered microcredit, which by design mostly goes to women. The social fabric of the country is changing as women are now much more likely to make family / economic decisions. Spending on children’s food, health and education has gone up. Women’s fertility rates have gone down significantly. At the same time, infant / maternal mortality rates have witnessed one of the fastest declines seen anywhere globally.   Chart 16Bangladesh’s Income Inequality Has Remained Low As Growth Has Been Inclusive Bangladesh’s income inequality – as measured by the Gini index – is one of the lowest in the world (Chart 16). What’s more, despite strong growth, inequality has not risen over the past 25 years. This is in stark contrast to many other advanced and developing countries. Such inclusive growth has rendered the society more equitable, making growth itself more sustainable. Bangladeshis have largely embraced their more liberal linguistic identity over their religious identity. For context, Bengali-speaking Bangladesh was born out of an extremely violent secession from the Urdu-speaking people of Pakistan in 1971 as the former realized that culturally their linguistic identity supersedes their religious identity.3  As such, the vast majority of Bangladeshis practice a moderate form of Islam. This factor has helped to encourage such social changes as the empowerment of women and the expansion of microcredit as religious / cultural opposition has been low. These major traits of this society, including those of gender and income equality, are likely to persist in the foreseeable future. Therefore, odds are that the strong growth will continue to remain inclusive and therefore sustainable. Investment Conclusions The Bangladeshi equity market exhibits a very low and often a negative correlation with both the EM and Emerging Asian markets. In particular, periods of global risk aversions, such as in 2014-15 and early 2020 saw the correlations turn negative. This increases market attractiveness to asset allocators as it will allow them to reap diversification benefits (Chart 17). That said, this bourse has risen significantly over the past year or so and has outperformed its EM counterparts (Chart 1 in page 1). Its valuations have also risen and are now on par with their EM peers (Chart 18). As such, there could well be a period of indigestion / consolidation – especially if our view of a stronger dollar and rising US bond yields transpires, and oil prices remain elevated over the next several months. Chart 17Bangladeshi Stocks' Correlation With EM Turns Negative During Bear Markets Chart 18Bangladeshi Stock Valuations Have Risen, But Are Not Excessive   Putting it all together, we recommend that absolute return investors with a time horizon of over one year should adopt a strategy of ‘buying on dips’ for Bangladeshi stocks. Dedicated EM/frontier market equity portfolios should consider overweighting Bangladeshi stocks. Finally, regarding the currency, the Bangladeshi taka will likely remain more or less stable over the next year or so. The taka rarely depreciates unless the country’s BoP begins to deteriorate materially. As explained above, that is not in the cards. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Bangladeshi central bank tries to control the ‘quantity’ of money/credit, rather than the ‘price (i.e., interest rate)’ to conduct its monetary policy. To explain, it controls the ‘reserve money’ growth and thereby impact the ‘broad money (M2)’ growth - to achieve its objectives on economic growth, inflation, and the exchange rate. 2 As per the United Nations’ World Population Prospects 2019. The same metric for Vietnam, Bangladesh’s main exports competitor, has peaked in 2015. 3 For a detailed account of the geopolitical outlook of Bangladesh and the larger South Asia, please see South Asia: A New Geopolitical Theatre from BCA’s Geopolitical Strategy team.

Highlights Energy Prices & Bond Yields: Surging energy prices are lifting inflation expectations in the US and Europe, while at the same time dampening consumer confidence amid diminished perceptions of real purchasing power. These conflicting trends are putting central banks in a tricky spot in the near-term, but tightening labor markets will force a more enduring need for dialing back global monetary accommodation in 2022, led by the Fed and the Bank of England. Stay below-benchmark on global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. High-Yield: Trans-Atlantic junk bond performance has diverged of late, with euro area spreads widening versus the US. This is a temporary distortion created by the pop in oil prices, with the Energy sector that benefits from higher oil prices representing a far greater share of the high-yield universe in the US compared to Europe. Maintain an overweight stance on European high-yield corporates. Feature Chart of the WeekGlobal Bond Yield Breakout? It is not easy being an inflation-targeting central bank these days. Soaring energy prices, with the Brent crude benchmark price climbing to a 3-year high of $86/bbl last week and natural gas prices up nearly four-fold year-to-date in Europe. These moves are adding upward pressure to inflation rates already elevated because of disrupted supply chains and rising labor costs. Government bond yields in the developed markets are moving higher in response, driven by rising inflation breakevens and increasing central bank hawkishness that is causing a stir in negative real yields (Chart of the Week). Among the three most important developed economy central banks - the Fed, the ECB and the Bank of England (BoE) – the most forceful signaling of a need for tighter policy is surprisingly coming from Threadneedle Street in London, home to one of the most dovish central banks since the 2008 crisis. Numerous BoE officials, including Governor Andrew Bailey, have strongly hinted that UK rate hikes could begin as soon as next month’s policy meeting. Fed officials have suggested a similar timetable for the start of the QE taper. By contrast, members of the ECB Governing Council have paid lip service to the recent sharp pickup in euro area inflation but, for the most part, have stuck to the view that it will not last long enough to justify a policy response. The relative hawkishness among “The Big Three” central banks fits with our current recommended strategy on global duration exposure, staying below-benchmark, and country allocation, with the largest underweights to US Treasuries and UK Gilts. Should Central Banks Focus More On Inflation Or Growth? Monetary policymakers are in a difficult spot at the moment. Rising energy prices have breathed new life into inflation, and inflation expectations, even as global growth momentum has cooled off somewhat. Given the magnitude and breadth of the global energy price surge – even coal prices in China have shot up 120% since late August - it will be difficult for central bankers to “see through” the inflationary implications and worry more about growth (Chart 2). Rising energy prices are likely to extend the current global inflation upturn that has already gone on for longer than expected because of supply-chain disruptions. This raises the risk that consumers could turn more cautious on spending behavior if they have to devote more of their incomes just to fuel their cars or heat their homes. In the US, this dynamic already appears to be playing out. The acceleration of inflation has broadened out, with the Cleveland Fed’s trimmed mean CPI inflation measure (which removes the most volatile components of the CPI) rising to 3.5% in September (Chart 3, top panel). With US consumers seeing higher prices on a wider range of goods and services, they have raised their inflation expectations. The preliminary October University of Michigan US consumer confidence survey showed that 1-year-ahead inflation expectations rose to a 13-year high of 4.8% (middle panel). Chart 2Pouring Gas On Global Inflation The New York Fed’s consumer survey showed a similar 1-year-ahead inflation forecast (5.3%), which is well above the forecast for income growth in 2022 (2.9%). Combining those two measures shows that US consumers implicitly see a contraction in their real incomes over the next 12 months. Chart 3US Consumers Expect A Sharp Decline In Real Purchasing Power This has likely played a big role in the sharp fall in the University of Michigan consumer confidence index since the peak back in June (bottom panel), despite favorable US labor market conditions. US consumer perceptions of inflation appear much greater than the reality of inflation evident in the official price indices. The New York Fed survey also asks US consumers what their 1-year-ahead expectations are for major spending categories, like food or rent (Chart 4). Consumers expect somewhat slower inflation for food (7.0%) and gasoline (5.9%) over the next year, yet they also expect much higher medical care costs (9.4%) and rent (9.7%). For the latter two, those are considerably higher than the latest actual inflation rates seen in the US CPI (2.4% for rent, 0.4% for medical care) or PCE deflator (2.1% for rent, 2.4% for medical care). Taking these survey results at face value, it is likely that US consumers are overestimating how much their real incomes will suffer next year from higher inflation. This is especially true as US household income growth will likely surpass the 2.9% estimate seen in the New York Fed survey. Yet that does not preclude the Fed from starting to turn more hawkish. Central bankers are always on the lookout for signs that higher realized inflation is feeding through into rising inflation expectations, which could require a policy tightening response to prevent an overshoot of inflation targets. The Fed has given itself a bit more leeway in that regard by altering their policy framework to allow temporary deviations of inflation from the central bank targets. The BoE, however, has not given itself the same sort of flexibility, which is why it is now signaling an imminent rate hike in response to survey-based inflation expectations, and breakeven inflation rates on longer-dated index-linked Gilts, climbing to close to 4% (Chart 5). Yet even the Fed, with its Average Inflation Targeting framework, has signaled that a tapering of its bond purchases will likely begin by year-end. Chart 4US Consumer Inflation Expectations Well Above Actual Inflation Markets are looking at the persistence of high inflation and have priced in a more hawkish trajectory for interest rates in the US, UK and even Europe over the next 12-24 months (Chart 6, bottom panel). Chart 5Inflation Weighing On UK & European Consumer Confidence Real bond yields in those regions are also starting to move higher in response to rising rate expectations (third panel) - a bond-bearish dynamic that we have discussed at length in recent reports.1 Between those three, the BoE’s hawkish turn has hammered the Gilt market the hardest. Yet there has definitely been a spillover into rate expectations and bond yields in other countries on the back of the BoE guidance. We have already seen rate hikes from smaller developed market central banks, Norway and New Zealand, over the past month. If a major central bank like the BoE soon follows suit because of overshooting inflation expectations, then markets are justified in thinking that the Fed or even the ECB could be next. Of those “Big 3” central banks, we see the ECB as being the least likely to respond to the current inflation upturn with rate hikes in 2022. There is simply not enough evidence suggesting that the energy/supply-chain driven inflation in the euro area is broadening out into other parts of the economy on a sustainable basis. Furthermore, there is already some degree of monetary tightening “scheduled” in 2022 when the ECB’s pandemic bond purchase program expires in March. The ECB will not want to compound that by moving into rate hiking mode soon after. On the other hand, the Fed will likely see enough further tightening of US labor market conditions to begin hiking rates in the fourth quarter of 2022 (Chart 7). In the UK, After next month’s likely rate hike, the BoE will need to deliver at least another 50-75bps of additional hikes in 2022 and likely more in 2023 with real policy rates already well below neutral before the latest spike in energy prices. Chart 6Expect Higher Real Yields As Central Banks Turn More Hawkish Chart 7Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 With the Fed and BoE set to be far more hawkish than the ECB next year, we see greater risks of government bond yields rising faster, and higher than current forward rates, in the US and UK compared to the euro area (Chart 8). This justifies an overall cautious strategic stance on duration exposure in global bond portfolios. With regards to inflation-linked bonds, however, we recommend only a neutral overall stance. Elevated inflation breakevens have converged to, or even above, central bank inflation targets in all developed market economies (excluding Japan). 10-year UK breakevens, in particular, look very expensive on our fair value model (Chart 9). Chart 8Our Recommended "Big 3" Country Allocations Chart 9Maintain An Overall Neutral Stance On Inflation-Linked Bonds Bottom Line: Our view on the policy decisions of the Big 3 central banks in 2022 informs our strategic (6-18 months) investment strategy within those markets. Stay below-benchmark on overall global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. Fade The Recent Backup In European High Yield Spreads Chart 10A Slight Pickup In European Junk Spreads Corporate credit markets in the US and Europe have calmed down since the July/August “Delta fueled” selloff with one notable exception – European high-yield (HY). The Bloomberg European HY index spread now sits 39bps above the September low, noticeably diverging from the US HY index spread (Chart 10). We view those wider spreads as a tactical buying opportunity for European junk bonds, both in absolute terms and versus US junk bonds. The recent underperformance appears rooted in soaring European energy prices. The spread widening has been concentrated in European consumer sectors (both cyclicals and non-cyclicals) that would be more exposed to the drain on real incomes from booming natural gas prices. Energy is also a smaller part of the European high-yield index (2%) compared to the US HY index (13%), which helps explain the performance gap with the US – the US index is more exposed to companies that benefit from higher energy prices (Chart 11). Chart 11Sectoral Breakdown Of US & Euro Area High-Yield Indices Over a more medium-term perspective, there is little reason why there should be a meaningful performance difference between US and European HY. The path of spreads and excess returns (versus duration-matched government debt) for the two markets have been highly correlated in recent years (Chart 12). When adjusting European HY returns to allow a proper apples-to-apples comparison to US HY – by hedging European returns into US dollars and controlling for duration differences between the two markets – there has been little sustained difference in returns dating back to 2018. Chart 12Euro Area HY Has Closed The Gap Vs. The US Chart 13Junk Default Rates Will Stay Low In 2022 More fundamentally, there is little difference in default rates that would justify a major divergence of HY spreads on both sides of the Atlantic. Moody’s is forecasting a HY default rate for a rate of 2% in both the US and Europe for 2022 (Chart 13). Such similar default rate expectations make sense with economic growth likely to remain well above trend in 2022 in both the US and Europe. Higher inflation will also boost nominal GDP growth, helping lift corporate revenues and the ability to service debt. From a valuation perspective, there is also little to choose from between European and US HY: The default-adjusted spread, which takes the current HY index spread and subtracts expected default losses over the next twelve months, is 196bps in Europe and 166bps in the US (Chart 14). While those spreads are below the post-2000 mean in both markets, they are still above past valuation extremes. The percentile ranking of 12-month breakeven spreads (the amount of spread widening over one year that would eliminate the yield advantage of HY over duration-matched government bonds) are also similar, 25% for European HY and 26% for US HY (Chart 15). These suggest HY spreads are not particularly “cheap”, from a historical perspective, in either market, but they could move lower to reach previous historical extremes. Chart 14Low Expected Default Losses Supporting HY Valuations Chart 15Overall HY Spreads Are Tight In The US & Europe Chart 16Euro Area Ba-Rated HY Spreads Look More Attractive Summing it all up, there is no discernable reason why European HY should trade at a sustainably wider spread to US HY, outside of the compositional issue related to the weight of the Energy sector in both markets. When breaking down the two markets by credit rating buckets, European Ba-rated corporates even look more attractive versus similarly-rated US corporates, based on 12-month breakeven spread percentile rankings (Chart 16). Bottom Line: Maintain a strategic overweight stance on European high-yield corporates, and tactically position for some relatively better performance of European junk bonds versus US equivalents.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "What If Higher Inflation Is Not Transitory?", dated September 23, 2021, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning   Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Duration: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. Nominal Treasury Curve: We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener. The Long And Short Of It Chart 1Short-End Joins The Selloff It’s still a bit early for a 2021 retrospective, but unless something dramatic happens during the next 2 ½ months it’s likely that the year will go into the books as a bad one for US bonds. Looking back, we can identify three phases of bond market performance in 2021. First, a selloff in long-dated bonds early in the year driven by economic re-opening and fiscal stimulus. Second, a partial reversal of this long-end selloff that lasted through the spring and early summer. Finally, a renewed selloff involving both the long and short ends of the yield curve (Chart 1). The Long End Looking first at the long end of the curve, we don’t see any immediate signs that yields have risen too far. Estimates of the 10-year term premium created by taking the difference between the spot 10-year Treasury yield and survey estimates of the future 10-year average fed funds rate show that the term premium is not as elevated as it was when yields peaked last March or when they peaked in 2018 (Chart 2). The 25-delta risk reversal on 30-year Treasury futures – a technical indicator with a strong track record of calling turning points in the 30-year yield – also remains below the 1.5 level that has historically signaled a peak in the 30-year yield (Chart 3). Table 1 shows that while it is rare for the risk reversal to rise above 1.5, such a move usually indicates that yields have risen too far, too fast Chart 210-Year Term Premium Still Low Chart 3Technicals Not Stretched Table 1Track Record Of Risk Reversal Indicator Finally, we look at the 5-year/5-year forward Treasury yield relative to a range of survey estimates of the long-run neutral fed funds rate (Chart 4). At 2.09%, the 5-year/5-year yield is close to median survey estimates of the long-run neutral fed funds rate.1 We take this to mean that the 5y5y yield has limited upside. Further increases in yields will take the form of the rest of the curve catching up to the 5y5y. Put differently, further increases in yields are more likely to coincide with curve flattening, not steepening.2  Chart 45y5y Is At Its Fair Value The Short End While long-maturity bond yields have moved up during the past few months, it is the breakout in short-maturity Treasury yields that has been the most notable feature of the recent bond selloff (Chart 1, bottom panel). In particular, near-term interest rate expectations have adjusted sharply higher since the September FOMC meeting (Chart 5). Prior to the September FOMC meeting, the overnight index swap (OIS) market was priced for Fed liftoff in February 2023 and for a total of 80 bps of rate hikes by the end of 2023. Now, the OIS curve is priced for Fed liftoff in September 2022 and for a total of 113 bps of rate hikes by the end of 2023. Chart 5Fed Funds Rate Expectations We continue to view the December 2022 FOMC meeting as the most likely date for the first rate hike. We also think it’s reasonable to expect the Fed to lift rates at a pace of 75-100 bps per year once tightening begins. In other words, we view fair pricing at the front-end of the curve as consistent with liftoff in December 2022 and a total of 100-125 bps of rate hikes by the end of 2023. The recent selloff has made front-end pricing more consistent with our assessment of fair value. Therefore, we don’t see any huge opportunities for directional bets on short-dated nominal yields. That said, we also contend that the bond market has arrived at the correct conclusion about the near-term pace of Fed tightening, but for the wrong reason. As is discussed in the next section of this report (see section titled “Massive Upside In Short-Maturity Real Yields”), this presents some attractive opportunities to trade short-maturity real yields and short-maturity inflation breakevens. One other observation from Chart 5 is that the market’s expected pace of Fed tightening flattens off considerably in 2024 and beyond. The market is priced for a mere 34 bps of tightening in 2024 and 2025 and the fed funds rate is still expected to be below 1.6% by the end of 2025. This highlights that, while pricing at the front-end of the yield curve looks reasonable, yields with slightly longer maturities remain too low. Bottom Line: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Massive Upside In Short-Maturity Real Yields Table 2Yield Changes Since September FOMC (BPs) The prior section noted that the market’s near-term rate expectations have risen considerably during the past few weeks. While we think that pricing looks reasonable compared to our own monetary policy expectations, we alluded to the idea that the market has brought forward its rate hike expectations for the wrong reason. Table 2 illustrates what we mean. Practically all the increase in nominal Treasury yields since the September FOMC meeting has been driven by a rising cost of inflation compensation. Real yields, on the other hand, have either been relatively stable (for long maturities) or have fallen massively (at the short-end of the curve). In fact, the 2-year real yield has declined 34 bps since the September FOMC meeting even as the 2-year nominal yield has increased by 16 bps. What the stark divergence between real yields and the cost of inflation compensation tells us is that the market is concerned that inflation may not fall as much as was previously assumed and the Fed may be forced to tighten more quickly in response. First off, we think concerns about persistently high inflation are a tad overblown. It’s certainly true that 12-month headline and core CPI inflation remain extremely high, at 5.4% and 4.0% respectively, but 3-month rates of change have moderated during the past few months and the 12-month figures will soon follow suit (Chart 6). Second, even if inflation is slow to moderate, the composition of what is driving that high inflation has implications for how the Fed will respond. Specifically, if elevated inflation continues to be driven by extreme readings from a few sectors that have been inordinately impacted by the pandemic, the Fed will be inclined to write-off that inflation as “transitory” while it awaits more broad-based inflationary pressures driven by tight labor markets and accelerating wages. It continues to be worth noting that after stripping out COVID-impacted services and cars, core inflation remains well contained near levels consistent with the Fed’s target (Chart 7). Chart 6Inflation Is Falling Chart 7Inflation Pressures Are Narrow In a speech last week, Atlanta Fed President Raphael Bostic said that the Fed should use the word “episodic” instead of “transitory” to describe the nature of the current inflationary shock.3 The problem with the word “transitory” is that it is linked to a notion of time. It implies that inflation pressures are expected to fade quickly, but this is not the message that the Fed meant to convey with that word. Rather, in Bostic’s words, the Fed meant to convey that “these price changes are tied specifically to the presence of the pandemic and, once the pandemic is behind us, will eventually unwind, by themselves, without necessarily threatening longer-run price stability.” In other words, the Fed will not tighten policy to lean against narrow inflationary pressures driven by a few sectors that can easily be traced back to the pandemic. Rather, the Fed will only respond if inflationary pressures are sufficiently broad and/or if long-run inflation expectations become un-anchored to the upside. On the first point, there is some evidence that inflation pressures are broadening. As of September, 49% of the CPI index was growing at a 12-month rate above 3%, up from a 2021 low of 22% (Chart 8). However, long-run inflation expectations remain well-anchored near the Fed’s target levels (Chart 9). Chart 8CPI Breadth Indicator Chart 9Long-Term Inflation Expectations Our sense is that inflationary pressures will fade during the next 12 months as pandemic fears abate. Long-dated inflation expectations will remain close to current levels, but short-dated inflation expectations will fall. The Fed will start to lift rates in December 2022 as broad-based inflationary pressures emerge, but inflation will be only slightly above the Fed’s target by then. The best way to position for this outcome is to go short 2-year TIPS. The cost of 2-year inflation compensation will fall as inflation moderates during the next 12 months, but the nominal 2-year yield will rise modestly as we advance toward a Fed tightening cycle. These two factors will combine to drive the 2-year real yield sharply higher (Chart 10). If you prefer not to put on an outright short 2-year TIPS position, there are a few other ways to position for the same trend. First, investors could position for a steeper inflation curve. Chart 11 shows that the cost of short-maturity inflation compensation is much further above the Fed’s target level than the cost of long-maturity inflation compensation. Further, Table 3 shows that monthly changes in the cost of short-maturity inflation compensation are more sensitive to CPI than are changes in the long-maturity cost of inflation compensation. This means that the inflation curve will steepen during the next 12 months as inflation moderates and the short-term cost of inflation compensation falls. Chart 10Short 2-Year TIPS Chart 11Position For Inflation Curve Steepening... Table 3Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present)   Second, you could also position for a flatter TIPS yield curve (Chart 12). The combination of inflation curve steepening and nominal curve flattening will lead to a supercharged flattening of the real yield curve during the next 12 months. Chart 12... And Real Yield Curve Flattening Bottom Line: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The median response from the New York Fed’s Survey of Market Participants pegs the long-run neutral fed funds rate at 2.0%. The same measure from the Survey of Primary Dealers sits at 2.25%. 2 For more details on the relationship between the proximity of the 5-year/5-year yield to its fair value range and the slope of the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 3 https://www.atlantafed.org/news/speeches/2021/10/12/bostic-the-current-inflation-episode.aspx Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Chart 7Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/

Highlights A perfect storm has engulfed global energy markets. Strong economic growth, adverse weather conditions, and politically-induced supply disruptions have caused energy prices to surge. Fortunately, the global economy has become less vulnerable to energy shocks. Not only has the energy intensity of the global economy declined over the past few decades, but central banks are now less inclined to respond to higher energy prices by raising interest rates. Stock returns have been positively correlated with oil prices over the past decade. This suggests that equities can withstand the current level of oil prices. Markets are betting that energy prices will come down. Yet, given the diminished feedback loop between higher energy prices and slower economic growth, energy prices can stay elevated for longer than the market is discounting. We remain long the December 2022 Brent Crude futures contract as well as the Russian ruble and the Brazilian real. Value stocks are a cheap and effective hedge against higher-than-expected inflation. A Perfect Storm For Energy Markets Global energy prices have soared (Chart 1). The price of crude, having fallen into negative territory in April 2020, currently trades at over $80 per barrel. Natural gas prices have jumped more than three-fold in the UK and across much of continental Europe since March. In the US, the price of natural gas has doubled. Chart 1Natural Gas Prices Have Dipped, But Are Still Up Massively On The Year Chart 2Global Industrial Production Is Back Above Pre-Pandemic Levels   A perfect storm has driven up energy prices. The reopening of the global economy has supported energy demand. A surge in spending on goods has depleted inventories, forcing producers to ramp up output. Global industrial production is 8% higher than in January 2020 (Chart 2). Merchandise trade has recovered more quickly than expected (Chart 3). Chinese exports are up 28% from the start of the pandemic (Chart 4). Electricity consumption in China is running 7.5% above trend (Chart 5).   Chart 3World Trade Has Recovered Faster Than Expected Chart 4China's Export Sector Is Booming Chart 5Strong Manufacturing Activity Has Pushed Up Electricity Demand In China   Weather has amplified the tightness in energy markets. A cold snap across the Northern Hemisphere this spring depleted natural gas supplies (Chart 6). Compounding the problem, a lack of wind reduced energy production by European wind farms, leading to a shift toward natural gas and coal for power generation. A hot summer in Northern Asia raised electricity demand. Flooding in China and Indonesia curbed coal output, while a drought in Brazil reduced hydroelectric generation. Chart 6Natgas Storage Remains Tight Political Factors Policy developments have contributed to the dislocations in energy markets. China has been trying to wean itself off coal, which still accounted for 63% of electricity generation in 2020 (Chart 7). For a while, Australian coal imports made up for the lack of domestic coal production, but those disappeared last year following a diplomatic row between the two nations (Chart 8). To fill the energy gap, China has stepped up purchases of natural gas from Russia. Chart 7China Has Been Trying To Shift Away From Coal Chart 8A Lack Of Aussie Coal Imports Has Depleted Chinese Coal Inventories Never one to miss an opportunity, Russia has taken advantage of the natural gas shortage by pushing Germany to approve the newly completed Nord Stream 2 pipeline. The US$11 billion pipeline carries gas directly to Germany. Built under the Baltic  Sea, it bypasses Ukraine and thus deprives the NATO-allied government in Kyiv of as much as $2 billion a year in transit fees. The pipeline was backed by outgoing chancellor Angela Merkel and has the strong support of the German public (Chart 9). However, opposition from the US has kept the project in limbo. Texas Senator Ted Cruz has blocked approval for President Biden’s nominees to various departmental posts in an effort to halt the pipeline. Chart 9Germans Say "Ja" To Nord Stream 2 Cruz has justified his actions on foreign policy grounds. However, economics has probably also played a role: The US is Europe’s top supplier of liquefied natural gas. Texas exported 2.5 trillion cubic feet of natural gas last year. It’s Not Just ESG Years of subpar investment in the energy sector have exacerbated the crisis. Globally, oil and gas capex is down 60% since 2014 (Chart 10). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Gas reserves followed a similar trajectory, increasing by only 5% between 2010 and 2020 compared to 30% over the prior ten years (Chart 11). It would be easy to blame ESG for this predicament, but the truth is that energy had been a lousy sector for investors until recently. The shares of global energy companies have risen just 25% since March 2009, compared to 315% for the MSCI All-Country World Index (Chart 12). Chart 10Energy Producers Have Not Been Investing Much In New Capacity Chart 11Oil And Gas Reserves Have Barely Grown Over The Past Decade   The Global Economy Is Less Dependent On Energy Could the jump in energy prices torpedo growth? It is possible, but the bar for an energy-induced recession is much higher than in the past. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies. Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970 (Chart 13). Chart 12Low Returns On Capital Have Reduced Investment In The Energy Sector Chart 13The Global Economy Has Become Less Energy Intensive Over Time   In the US, household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.5% in August 2021, the latest month of data. Chart 14When It Comes To Energy Production, The USA Is Now #1 While the recent run-up in energy prices will push up that number towards 4% in October, US consumers are well positioned to absorb the blow. Last week’s “disappointing” September jobs report saw private-sector employment rise by 317,000. Combined with an increase in the average length of the workweek, aggregate hours worked rose by 0.8% on the month – equivalent to 1,036,000 new private-sector jobs. Improved conditions for energy producers will also help insulate the US economy. The US now produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 14). Higher energy costs will exact more of a toll on European growth. However, as Mathieu Savary, BCA’s Chief European Strategist, recently argued, the region is likely to weather the storm given current strong growth momentum. Central Banks No Longer Fret Over Higher Oil Prices Helping matters is the fact that central banks are no longer responding to rising energy prices like they once did. Up until the Global Financial Crisis, the Fed would often lift rates whenever oil prices jumped (Chart 15). Since then, the Fed has looked through oil price fluctuations, a sensible strategy considering that core inflation is no longer highly correlated with oil prices (Chart 16). Chart 15Rising Oil Prices No Longer Scare The Fed Chart 16Oil Spikes No Longer Feed Into Core Inflation Like They Used To     The ECB has also changed tack. Jean-Claude Trichet disastrously hiked rates when oil prices reached $140/bbl in 2008, just as the global economy was heading off a cliff. Having failed to learn from his mistake the first time around, he then pushed the ECB to raise rates two times in 2011, helping to set off the euro area debt crisis. Mario Draghi and Christine Lagarde have followed a different course. In her speeches, Lagarde has pushed back on any talk that the ECB will expedite policy normalization. “The lady isn’t tapering,” she said on September 9th, echoing Margaret Thatcher’s famous proclamation. Energy Prices Should Come Off The Boil, But Geopolitics And The Weather Are Wild Cards Chart 17US Rig Count Has Risen From Low Levels Looking out, a number of factors should help restore balance to the energy market. The US rig count, while still far below its 2014 highs, has doubled since last year (Chart 17). It usually takes 6-to-9 months for a newly deployed rig to start producing output. China has instructed 170 coal mines to expand capacity. It has also allowed utilities to charge higher prices, helping to stave off bankruptcies across the sector. In addition, it is releasing some Australian coal from storage, potentially a first step towards restarting imports. Still, there are many wild cards at play that could cause energy prices to rise further. In addition to uncertainty over Chinese energy policy and the ongoing dispute over the Nord Stream 2 pipeline, the situation in Iran remains volatile. Matt Gertken, BCA’s Chief Geopolitical Strategist, believes that Iran could secure enough enriched uranium to make a nuclear device by the end of the year. In his opinion, “a crisis over Iran is imminent.” Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Furthermore, there is continued uncertainty about OPEC’s strategy. So far, OPEC and its partners have been reluctant to boost production. The general feeling among market participants is that OPEC would increase output if oil prices rose towards $100/bbl for fear that excessively high prices would expedite the adoption of electric vehicles. At this point, however, that electric horse has left the barn. OPEC may simply decide that it is better to wrangle out as much revenue from its reserves while they still have value. Weather also remains a wild card. The US Climate Prediction Center estimates that there is a 70%-to-80% chance that La Niña will return this winter. La Niña typically results in colder temperatures across much of Western and Northern Europe, which would lead to higher electricity demand. Investment Implications Markets are betting that energy prices will come down. The futures curves are in backwardation (Chart 18). Investors expect oil, gas, and coal prices to decline over the coming months (Chart 19). Chart 18Energy Futures Are In Backwardation Chart 19Investors Expect Commodity Prices To Fall     One does not need to bet on higher energy prices these days to make money from being long energy futures; one only needs to bet that prices will not fall as much as currently discounted. Given the diminished feedback loop between higher energy prices and slower economic growth, the view of BCA’s Commodity and Energy Strategy service, led by Bob Ryan, is that energy prices can stay elevated for longer than the market is discounting. Chart 20Stock Prices Are Now Positively Correlated With Oil We remain long the December 2022 Brent Crude futures contract as well as the Russian ruble and the Brazilian real. Stock returns have been positively correlated with oil prices over the past decade (Chart 20). This suggests that equities can withstand the current level of oil prices. Some stocks will do better than others, however. Energy and banks are overrepresented in value indices (Table 1). Energy stocks will do well if oil prices remain buoyant (Chart 21). For their part, banks should also outperform the market if bond yields continue to drift higher (Chart 22). Table 1Breaking Down Growth And Value By Sector Chart 21Higher Oil Prices Are A Tailwind For Energy Stocks Chart 22Bank Stocks Tend To Outperform When Yields RiseChart 23Inflation Expectations Are Highly Correlated With Oil Prices     In fixed-income portfolios, we continue to prefer TIPS over nominal bonds. Chart 23 shows that the 5y/5y forward TIPS breakeven inflation is highly correlated with oil prices. Thus, overweighting TIPS remains an effective hedge against an oil spike.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com       Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations