Consumer

Highlights The bull run in Vietnamese stocks is due for a pause as the weakness in overall EM markets spreads to this bourse.  Household consumption will stay constrained as new COVID-19 cases remain high and fiscal and monetary stimulus remain absent. Social distancing measures and related supply disruptions have hobbled labor-intensive manufacturing and exports thereof. Vietnam is facing saturation or stagnation in two of its major exports: electronics and phones. The country needs to find a new high value-added export sector to which to transition to maintain large trade surpluses. Vietnam’s longer-term structural outlook remains bright. The country is set to gain further global export market share due to strong productivity gains and competitive unit labor costs.  Absolute-return investors should book profits on their Vietnamese holdings for now and wait for a better entry point. Asset allocators, however, should continue to overweight this bourse in overall EM, emerging Asia or frontier market equity portfolios. Feature Vietnamese stocks have surged to new highs in absolute terms and have outperformed their frontier and emerging market peers since spring 2020 (Chart 1). Can the bull run continue into the new year? We advise caution. Vietnamese stocks may be in for a period of weakness in absolute terms. The reason is a negative outlook on EM markets: a drop in EM stock prices is typically followed by one in Vietnamese stock prices (Chart 2).   Chart 2Weakness In EM Markets Typically Spreads To Vietnamese Stocks Too Chart 1The Bull Run In Vietnamese Stocks May Be Due For A Pause   In addition, Vietnam’s exports, the mainstay of this market, are likely to face some headwinds in the months ahead. Absolute-return investors therefore would do well to book profits now and wait for a better entry point to this bourse later in the year. That said, the longer-term outlook of this economy remains bright, and that will help boost this market beyond any near-term jitters. Robust fundamentals should also ensure continued outperformance relative to overall EM stocks. We recommend that investors stay overweight Vietnam in EM and emerging Asian equity portfolios. Battered Consumption The surge in daily new cases since August last year forced Vietnam to implement stringent lockdowns and social distancing measures. A consequence of these measures was a free fall in Vietnam’s household consumption. Both retail sales and car sales plummeted to levels not seen since 2016 before recovering recently (Chart 3). This caused the economy to shrink by over 6% in real terms in the third quarter last year – the first-ever contraction in decades. Now, with the new, highly infectious Omicron variant spreading fast, the number of daily new cases and deaths remains stubbornly high – despite many of the lockdown measures still in place (Chart 4). It is therefore far from clear when normal economic activity will resume. Incidentally, 57% of Vietnamese people have been fully vaccinated so far. Chart 4Rising Omicron Cases May Hobble Economic Activity Again Chart 3The Surge In The Delta Variant Last Year Severely Hurt Vietnamese Household Consumption   Notably, despite the weak economy, there has not been any meaningful policy stimulus in recent months. Fiscal policy has remained very tight. Government spending, excluding interest and principal payments, has contracted by 4.5%. The 2022 budget proposals envisage only a 2% rise in total nominal fiscal expenditure. The central bank, for its part, has also not announced any new easing measures in the recent past. Lacking fiscal and monetary support, domestic consumption and therefore overall growth will remain somewhat constrained going forward. Supply Disruptions While domestic consumption is a concern, a more investor-relevant issue in Vietnam is the pandemic’s negative impact on the country’s manufacturing/export sector. This is because, unlike household consumption, manufacturing activity and manufacturing exports have a strong bearing on the country’s stock prices. The reason is that developing market stocks in general are driven by global trade cycles. And since Vietnam’s total trade amounts to almost twice as much as the country’s GDP, the ebbs and flows in the former have an outsized impact on the domestic economy, and by extension, on the stock market (Chart 5). The surge in new cases since August created severe hindrances in the manufacturing/export sector supply chains and labor availability. In the clothing and textile industry, almost a third of the sector’s three million employees quit jobs, or stayed away from work with or without pay, as per Vietnam Textile & Apparel Association, an industry body.1The lack of labor coupled with bottlenecks in logistics have led to a sharp drop in Vietnam’s textile and garment exports (Chart 6, top panel).  Chart 6Garment Exports Are Badly Hit, While Phone Exports Are Facing Stagnation Chart 5Vietnamese Stocks Are Highly Leveraged To Export Growth   Due to hobbled production, manufacturing inventories have piled up (Chart 7). It is estimated that most of this large inventory is comprised of raw materials and intermediate goods. If so, that will discourage local raw material/intermediate goods production in the months to come. Chart 7The Pandemic Is Hampering Shipments While Inventories Are Piling Up In sum, it’s far from clear that a rapid revival in manufacturing production and exports is in the cards amid the ongoing Omicron surge. This will remain a headwind for Vietnamese stock prices. Exports Outlook Despite the setback in the textile sector, the country’s overall exports held up quite well last year. That’s because the slack was more than made up by the booming computer and electronics exports. This is thanks to the massive demand surge in those goods in past two years due to the global work-from-home phenomenon (Chart 6, top panel). However, going forward, odds are that global demand for these items will abate as saturation sets in. This will slow the growth rate in Vietnam’s computer and electronic exports. Incidentally, Vietnam’s single largest export items, phones and spare parts, are also showing signs of stagnation. In absolute dollar terms, they have been flattish since early 2018. Phone production volumes have remained at the same level as in 2015 (Chart 6, bottom panel). With mobile phone penetration in all major economies is already quite high, phone exports certainly cannot propel Vietnam’s exports as strongly as in the past decade. If this is the case, it can have a meaningful negative impact not only on Vietnam’s exports, but also on its trade balance, and by extension, its current account balance. The reason for this is that phones and spare parts have probably been the most value-added item among Vietnamese exports. The difference between the export revenues they earned and the import cost of the components has been much higher and has risen more sharply than in any other major export items (Chart 8, top and middle panels). This helped the country rack up rising trade surpluses. In the absence of net export revenues from phones and spare parts, Vietnam’s trade and current account balance would be deeply negative (Chart 8, bottom panel). Given that phones are no longer the sunrise sector worldwide, the country needs to find and move to some other high value-added sector to maintain its wide trade surplus. As of now, it’s not clear that this is happening. In the past two years, the number of newly approved manufacturing FDI projects have fallen to decade-low levels. The dollar value of approved manufacturing FDI projects has also fallen in tandem (Chart 9, top panel). In fact, overall FDI approvals have also fallen – suggesting actual FDI inflows might weaken in the months ahead (Chart 9, bottom panel). Chart 8Net Phone Exports Had Been Crucial To Vietnam's Large Trade Surpluses Chart 9FDI Inflows Into Vietnam Might Recede In The Coming Months   Until Vietnam finds a new high value-added export sector to which to transition, its stagnating phone and electronics exports mean that overall export growth is set to take a breather. Finally, one external tailwind for Vietnam since 2018 has been the trade war between the US and China. Because the two largest economies put various tariff and non-tariff barriers on each other, it allowed Vietnam to double its share of imports to the US in just three years (Chart 10). Vietnamese exports also clearly benefit when the dong weakens vis-à-vis the Chinese yuan. The fact that the Chinese authorities have allowed the yuan to be one of the strongest currencies over the past year has helped Vietnamese exports. In the future, however, decelerating growth in China may prompt the PBOC to seek a weaker yuan. If so, that could be another headwind to Vietnamese exports (Chart 11).       Chart 11The Tailwind From A Weak Dong Versus The Chinese Yuan May Diminish This Year, Hurting Exports Chart 10Vietnamese Exports Benefitted Immensely From The US-China Trade War   In sum, Vietnamese exports could well see a period of weakness in the coming months. That is usually a harbinger of weaker Vietnamese stock prices in absolute terms (Chart 5, above). Structurally Sound Despite our near-term cautious outlook on Vietnamese stocks, we have a positive view on the country’s structural prospects. The country’s fundamentals remain robust and that will help propel this market beyond any near-term weakness: Vietnam has boosted capital spending in the past few years to reach an impressive 32% of GDP, among the highest in the developing world (Chart 12, top panel). This has helped raise the economy’s productive capacity. Consistently, Vietnam’s labor productivity gains have been superior to most developing countries (Chart 12, bottom panel). The country’s wage growth has been relatively lower than those of China and Bangladesh, its two main export competitors (Chart 13, top panel). Chart 12Vietnam's Capital Spending And Labor Productivity Remains Among The Highest In EM Chart 13Competitive Unit Labor Costs Are Helping Vietnam Rapidly Grab Global Market Share Stronger productivity gains coupled with relatively muted wage growth is helping keep Vietnamese unit labor costs lower than its competitors. This is boosting its competitiveness; and not only helping grab an ever higher global market share, but also doing so at a faster clip than even China and Bangladesh (Chart 13, bottom panel). The country is also well placed to take advantage of its competitive unit labor costs. It has entered into a number of free trade agreements (FTA) with many countries and regions, the latest of which is the RCEP agreement – comprising ASEAN, China, Japan, South Korea, Australia, and New Zealand – which kicked in this January. These FTAs have eliminated export import tariffs for hundreds of items. Vietnam is likely to be a major beneficiary of these treaties in the medium to long term, given its rising competitiveness.  Given the already available infrastructure and labor and its competitive edge in manufacturing, Vietnam is also set to be the major recipient of the firms relocating away from China. This will further boost its longer-term prospects as exports will continue to generate solid income growth. Overall, real income per capita in Vietnam will continue rising at a rapid rate, outpacing that of most emerging economies. Investment Conclusions Chart 14Vietnamese Stock Valuations Are Not Attractive Now Since the country’s exports will likely decelerate in the coming months, its share prices will also likely correct. In addition, the ongoing sell-off in EM risk assets has further to run, as explained in our last report, EM: A Perfect Storm. This is a harbinger of weaker Vietnamese stock prices. What’s more, a sell-off in EM risk assets is often associated with a considerable decline in capital inflows into Vietnam – as was the case in 2015 and 2018. Those periods were negative for Vietnamese stocks as well.  Finally, valuations are not attractive either. Trailing P/E and P/Book ratios of Vietnamese stocks are much higher (21 and 3.6, respectively) compared to those of EM (14 and 1.9) and frontier market (15.5 and 2.3) stocks (Chart 14). Putting it all together, absolute-return investors should book profits on their Vietnam holdings and wait for a better entry point. Asset allocators, however, should continue to maintain their overweight positions on Vietnamese stocks, in EM, emerging Asia or frontier market equity portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1     Please refer to “Vietnam garment exports hit hard by labor shortage, disrupted supply chains, and swelled freight fares” on Textile Today Bangladesh.

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022​​​​​ Chart 2Strong Fundamental Support For US Growth​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability​​​​​​ In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022​​​​​​ When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@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 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1.  How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2.    Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend   Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-7). The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4.    How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive.  This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5.    Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6.    How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7.    Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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 Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Dear Client, The next two BCA Research Global Fixed Income Strategy reports will be jointly published with other BCA services, which will impact the publishing dates. Our next report will be a joint Special Report on Australia, published with our colleagues at Foreign Exchange Strategy, which you will receive this Friday, November 19. The following report will be a joint Special Report published with European Investment Strategy, which you will receive on November 29. -Rob Robis   Highlights High realized inflation rates are pushing up longer-term inflation expectations toward all-time highs, while also weighing on consumer confidence, in the US and the UK. The inflation overshoot has not been as severe in the euro area, but consumer confidence appears to be rolling over there too. Over the next year, central banks will have to manage around the communications challenges posed by a rise in inflation that is perceived to be more supply-driven than demand-driven and, hence, beyond the full control of monetary policy. Public opinion surveys are showing eroding satisfaction with the Fed and Bank of England, while similar surveys in the euro area show public trust in the ECB remains strong despite higher euro area inflation.  We continue to favor overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23, compared to the euro area, in order to restore central bank credibility.  Feature Rapidly accelerating inflation has become front-page news around the world. It is also increasingly becoming a political issue and not just an economic one. After the release of the October US consumer price index (CPI) report, where headline inflation came in at a 30-year high of 6.2%, US President Joe Biden had to issue a formal White House statement acknowledging that inflation “hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” Biden also pulled off the neat trick of both committing to, and subtly challenging, the Fed’s independence when he noted that “I want to reemphasize my commitment to the independence of the Federal Reserve to monitor inflation, and take necessary steps to combat it.” The Great Inflation Of 2021 (and 2022?) has raised a new risk for both politicians and investors. As long as the high inflation persists, and for as long as central banks seem unwilling or unable to respond to try and bring down inflation with tighter monetary policy, consumer confidence will be negatively impacted – even if job growth remains reasonably healthy. Confidence & Inflation: A Matter Of Trust Chart of the WeekHigh Inflation Weighing On Consumer Confidence The preliminary read on US consumer confidence for November from the University of Michigan survey showed sentiment hitting a ten-year low, largely on worries about the impact of rising inflation on household spending power. This effect of high inflation eroding consumer confidence is not just a US phenomenon (Chart of the Week). UK consumer sentiment is also falling due to what has been described as “a potential cost of living crisis” by consumer research firm GfK. In the euro area, however, consumer sentiment is still relatively elevated, but is starting to roll over as headline inflation reaches a 13-year high of 4.1% in October. From the point of view of financial markets,  surging inflation is still expected to be a short-lived phenomenon, although conviction on that view is starting to wane. Market-based inflation expectations curves for the US, UK and euro area are all currently inverted, with shorter-maturity expectations above longer-maturity ones (Chart 2). Yet the upward momentum of those measures across all maturity points is showing little sign of ebbing, especially in the US. The 2-year TIPS breakeven rate now sits at a 16-year high of 3.51%, the 5-year breakeven is at an all-time high of 3.22%, while the 10-year breakeven of 2.77% is now just a single basis point below its all-time high reached in 2005. The story is similar in the UK, where RPI swap rates for the 2-year, 5-year and 10-year maturities are 5.3%, 4.8% and 4.3%, respectively – all hovering near all-time highs (as are breakevens on index-linked Gilts). Euro area inflation expectations are not so historically elevated, and the inflation curve is not as inverted, but the 2-year euro CPI swap rate is still at a 15-year high of 2.4% compared to a 9-year high of 2.0% - right at the ECB’s inflation target - for the 10-year CPI swap rate. In the US, the survey-based measures of inflation expectations are telling a similar story. The New York Fed’s Consumer Survey shows that median 3-year expectations are now at 4.2% with 1-year expectations even higher at 5.7% (Chart 3). Meanwhile, the early November read on inflation expectations from the University of Michigan survey showed that 1-year-ahead expectations climbed to a 13-year high of 4.9%, while the longer-term 5-10 year inflation expectations were unchanged from the October reading of 2.9%. Chart 2Rising Inflation Expectations, Both Short- & Long-Term Chart 3A Broad-Based Surge In US Inflation The latter figure may provide some comfort to the Fed, with surging shorter-term expectations not fully leaking through into longer-term expectations. However, the longer the inflation upturn persists, the more likely it will be that US consumers begin to factor in a higher rate of longer-term inflation, just as TIPS traders are doing. After all, the Michigan 5-10 year measure has still climbed by 0.7 percentage points from the pre-COVID low. Even more worrying from the Fed’s perspective is that inflation expectations are rising for essentially all Americans. The New York Fed Consumer Survey shows that 3-year-ahead inflation expectations are rising across all levels of education (Chart 4) and income cohorts (Chart 5). Chart 4US Inflation Expectations Are Rising For All Education Levels... Chart 5...And Income Levels The New York Fed also compiles a measure of consumer inflation uncertainty (bottom panels of both charts on page 5). Survey participants are asked to provide probabilities of inflation falling within certain ranges, with the gap between the top and bottom quartiles of those expected inflation outcomes representing the “uncertainty” over future US inflation. Perhaps unsurprisingly, the dispersion of inflation forecasts is typically much wider for those earning lower incomes and with less education. Yet even highly educated, high earning Americans are reporting wider gaps in possible inflation outcomes, in sharp contrast to the pre-COVID years where their expectations were low and stable. Americans Are Having Second Thoughts About The Fed Any way you cut it – TIPS breakevens or survey-based measures - US inflation uncertainty and volatility have increased. This appears to be starting to erode public confidence with the Fed. Along with its consumer confidence surveys, the University of Michigan also publishes a periodic survey of Confidence In Financial Institutions like commercial banks, asset managers and, most importantly, the Fed. The last survey was just conducted for the September/October 2021 period and showed that 43% of respondents reported a loss of confidence in the Fed compared to five years ago (Chart 6). That is up from 36% reporting a loss of confidence in the last such survey conducted in 2019, and is approaching the +50% levels seen in 2008 (the Financial Crisis) and in 2011 (the Taper Tantrum) – episodes where the Fed had difficulty maintaining economic and financial stability. The University of Michigan also noted that reported consumer confidence was much lower for those claiming to have less confidence in the Fed, and vice versa (Chart 7). Taken at face value, this survey shows that the Great Inflation of 2021 has shaken the public’s faith in the Fed’s ability to maintain economic stability. Combined with the message from the New York Fed Consumer Survey on the growing instability of American inflation expectations, this shows that the Fed may be facing an uphill climb to restore some of the credibility it has lost this year. Much like all aspects of American life these days, political partisanship must be factored in the analysis of US confidence data. The regular monthly University of Michigan sentiment survey for November noted that various measures of US confidence were consistently higher for respondents who reported to be Democrats compared to Republicans since President Biden took office (Chart 8). This is a mirror image of the years under President Trump (pre-pandemic), where Republicans consistently reported greater optimism than Democrats. Chart 9Americans Can Agree On One Thing - High Inflation Is Bad The University of Michigan Confidence in Financial Institutions survey also noted that less trust in the Fed was reported more frequently by Republicans (67%) than Democrats (27%) in 2021, the first year under Biden. This compares to 2017, the first year of the Trump Administration, where more Democrats (41%) reported less trust with the Fed compared to Republicans (30%). The Michigan survey described this “partisan identification” as being a “significant correlate of consumer assessments of the Federal Reserve, treating the Fed as part of the administration rather than an independent body.” Consumer confidence among reported Democrats has been falling since April of this year, although there is still room to catch up to the complete collapse of sentiment seen among Republican consumers (Chart 9, top panel). High US inflation is hitting everyone hard. The surge in inflation expectations is overwhelming income expectations for the next year, according to the New York Fed Consumer Survey (middle panel). High realized inflation has also eroded real spending power, with real average hourly earnings having contracted in year-over-year terms since April of this year (bottom panel). Even with that fall in real income growth perceptions, the plunge in the University of Michigan US consumer confidence has not been matched by other measures like the Conference Board US consumer confidence index, which remains well above pandemic era lows. Even more importantly, US consumer spending has held up well, with nominal retail sales expanding by +1.7% in October following a +0.8% gain in September. Some of those increases were due to rising prices, but were still significantly above inflation in both months, suggesting a solid pace of real consumer spending (the headline US CPI index rose +0.9% and +0.4% in October and September, respectively). For the Fed, the case is building to begin preparing Americans for higher interest rates in 2022. This is true both from an economic perspective – the US economy is likely to continue growing above trend next year, further tightening the US labor market – and in response to the high inflation that has caused some damage to the Fed’s credibility. What About The UK And Euro Area? Looking across the Atlantic, survey-based measures of inflation expectations have also climbed steadily higher (Chart 10). The YouGov/Citigroup survey of UK consumer inflation expectations is now at 4.4% for the 1-year-ahead measure and 3.7% for the longer-run 5-10 year ahead measure, both well above the BoE’s 2% inflation target. The European Commission surveys show a rapidly rising share of European Union businesses and consumers expect higher prices in the coming months. Yet while inflation expectations are rising in both the UK and Europe, only the UK shows the sort of deterioration in central bank confidence that is evident in the US. 48% of Europeans expressed confidence in the ECB, according to the Eurobarometer public opinion surveys – the highest share since 2007 and well above the 36% level seen after the Global Financial Crisis and European Debt Crisis (Chart 11). Some of that improvement in perceptions of the ECB mirrors better sentiment over the euro currency itself, as evidenced by that fact that both Germans and Italians now express similar levels of ECB confidence. Chart 10High Inflation Is Also A Problem Outside The US Chart 11Europeans Have Not Lost Confidence In The ECB High levels of public trust in the ECB play an important role in anchoring European inflation expectations. The ECB introduced its own Consumer Expectations Survey as a pilot project last year, and the latest reading from October 2021 shows that 1-year-ahead inflation expectations are now at 3% and 3-year-ahead expectations are at 2%. Both measures were at 2% a year earlier, and have generally stayed close to ECB’s 2% inflation target since the survey began. Chart 12High Inflation Is Worsening Public Satisfaction With The BoE A recent research report from the Bank of Finland concluded that European consumers who have high trust in the ECB adjust their medium-term inflation expectations more slowly than those with low trust. The high public confidence in the ECB seen in the Eurobarometer surveys, combined with the stability of medium-term inflation expectations (both survey-based and market-based) around the ECB’s 2% target – even with realized euro area inflation now at 3.4% - fits with the conclusions of that report. We read this as a sign that the ECB is not under the same growing pressure to tighten policy in the face of rising inflation as the Fed, which is facing an erosion of public confidence that is showing up in steadily rising inflation expectations. In the UK, the Bank of England (BoE) is facing a situation more akin to that of the Fed. The BoE’s Inflation Attitudes Survey has been showing a steady erosion of UK consumers reporting satisfaction with how the BoE has been setting policy to fight inflation (Chart 12). The “net satisfied” index fell to +18% in the last survey published in September – similarly low levels of BoE satisfaction coincided with major spikes in longer-term UK inflation expectations in 2008 and 2011 (bottom panel). Our conclusion from the UK consumer surveys, along with measures of inflation expectations that are well above the BoE medium-term target, is similar to that in the US. The UK public is losing faith in the BoE’s ability, or willingness, to tackle the high inflation “problem” – even if much of the inflation is caused by high energy prices and global supply chain disruptions that are beyond the immediate control of monetary policy. The BoE will likely need to follow through on the rate hikes markets expect in 2022 to help restore public trust and credibility, even if realized inflation slows from current elevated levels. This is especially true after the debacle of the November 4 BoE meeting where a widely-signaled rate hike did not occur. If the BoE continues to delay the start of tightening while inflation expectations are accelerating, this will only put more pressure on the central bank to tighten faster, and by more than expected, in a bid to stabilize inflation expectations. Investment Conclusions Chart 13Favor European Government Bonds Over US & UK Equivalents Our read of the various surveys shows that public trust in central banks has deteriorated in the US and UK, but not in Europe, because of surging inflation in 2021. This compounds the existing trends of tightening labor markets and accelerating wage growth in the US and UK that are more traditional reasons to tighten monetary policy. We continue to favor strategic overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23 in order to restore public trust in the Fed and BoE (Chart 13). The ECB can continue to be patient on responding to higher euro area inflation, given more stable euro area inflation expectations and with limited evidence that higher realized inflation is boosting European wage growth. Robert Robis, CFA Chief Fixed Income Strategist rrobis@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 There is a high risk of a global demand shortfall in 2022. This is because consumer demand for services will remain well below its pre-pandemic trend… …while the recent booming demand for goods is crashing back to earth. Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Fractal analysis: Overweight gas distribution. Feature Chart of the WeekSpending On Services In The US Is Still Far Below The Pre-Pandemic Trend. Will It Catch Up In 2022? With inflation surging, you would be forgiven for thinking that global demand is red-hot. Sadly, global demand is not red-hot. Two years after the pandemic began, the lynchpin of demand – consumer spending on services – remains far below its pre-pandemic trend. For example, US consumer spending on services is around $420 billion, or 5 percent, below where it should be (Chart I-1). A similar story holds true in the UK and France (Chart I-2 and Chart I-3). Chart I-2Spending On Services Is Still Far Below The Pre-Pandemic Trend In The UK... Chart I-3...And France Still, overall US consumer spending is on trend. Just. But only thanks to an unprecedented largesse of fiscal and monetary stimulus. Begging the question, what will happen when the stimulus ends? If overall stimulated spending is just on trend while spending on services is in deficit, it means that spending on goods is in a mirror-image $420 billion surplus. Which, given the smaller share of spending on goods, equates to 8 percent above where it should be. One misconception is that the surplus in goods spending is concentrated in durables. While this was true six months ago, two-thirds of the current surplus is in nondurables, dominated by clothing and shoes, food and drink at home, and games, toys and hobbies (Chart I-4). Chart I-4US Overspend On Durables Is Now $140 Bn, While Overspend On Nondurables Is $280 Bn Looking ahead, if the demand for goods crashes back to earth, as seems to be happening now, then the demand for services will have to catch up to its pre-pandemic trend. Otherwise there will be a deficit in aggregate demand. So, the crucial question for 2022 is, will services spending catch up to its pre-pandemic trend? Services Spending Will Remain Well Below Its Pre-Pandemic Trend Many people believe that the deficit in US services spending is due to the underspend in bars, restaurants, and hotels. In fact, this is another misconception. The underspending on ‘food services and accommodations’ is now a negligible $30 billion out of the $420 billion deficit. In which case, where is the deficit? Surprisingly, the biggest component is a $160 billion underspend on health care (Chart I-5). In particular, the spending on ‘outpatient physician services’ levelled off a year ago well below its pre-pandemic level (Chart I-6). A plausible explanation is that many doctor’s appointments have shifted to online, requiring much lower spending. The result is that health care consumption has slowed its convergence to the pre-pandemic trend, implying that a deficit could be persistent. Chart I-5US Underspend On Health Care ##br##Is $160 Bn Chart I-6US Spending On Physician Services Is Far Below The Pre-Pandemic Trend A second major component of the deficit is a $110 billion underspend on recreation services, as consumers have shunned the large or dense crowds in amusement parks, sports centres, spectator sports, and theatres. Some of this shunning of crowds will be long-lasting (Chart I-7). Chart I-7US Underspend On Recreation Services Is $110 Bn A third major component of the deficit is a $60 billion underspend on public transportation, as people have likewise shunned the personal proximity required in mass transit systems and aeroplanes. Some of this shunning of transport that requires personal proximity will also be long-lasting (Chart I-8). Chart I-8US Underspend On Public Transportation Is $60 Bn Worryingly, the recent spending on both recreation services and public transportation has stopped converging with the pre-pandemic trend. Admittedly, this might be a blip due to the delta wave of the pandemic, and spending could re-accelerate once this wave subsides. On the other hand, it would be prudent to assume that the delta wave was not the last wave of the pandemic and that further waves could arrive in 2022. Pulling all of this together, large parts of services spending will remain persistently below their pre-pandemic trend. Eventually, new and innovative types of services will plug this deficit, but this will take time. Therefore, we conservatively estimate that, at the end of 2022, US consumer spending on services will still be below its pre-pandemic trend by at least $200 billion, or 2.5 percent. Other major economies, like the UK and France, will suffer similar deficits. Goods Spending Will Crash Back To Earth Let’s now switch to the other side of the ledger, and assess to what extent the underspend in services can be countered by an overspend in goods. Spending on durables is already crashing back to earth. A surplus of $500 billion in March has collapsed to $140 billion now, and we fully expect it to fall back to zero. The reason is that durables, by their very definition, provide long-duration utility. Meaning that there are only so many cars, smartphones, and gadgets that any person can own. But what about the current $280 billion surplus on nondurables – can that be sustained? The biggest component of the nondurables surplus is a $85 billion, or 20 percent, overspend on clothes and shoes. Some of this overspend is justified by a wardrobe transition to the post-pandemic way of working and living. But clothes and shoes, though classified as nondurable, are in fact quite durable. Meaning that once the wardrobe transition is complete, we do not expect people to spend 20 percent more on clothes and shoes than they did before the pandemic (Chart I-9). Chart I-9US Overspend On Clothes And Shoes Is $85 Bn A second major component of the nondurables surplus is a $75 billion, or 7 percent, overspend on food and beverages at home. To a large extent, this has been a displacement of the underspending on eating and drinking out. But given that this underspend on eating and drinking out has almost normalised, we expect the overspend on eating and drinking at home to fade (Chart I-10). Chart I-10US Overspend On Food And Drink At Home Is $75 Bn A third major component of the nondurables surplus is a $45 billion, or 16 percent, overspend on recreational items: games, toys, hobbies, and pets and pet products (Chart I-11 and Chart I-12). To a large extent, this has been a displacement of the underspend on recreation services involving crowds, which will last. Hence, we expect the nondurable surplus on recreational items also to last, to the benefit of the animal care sector and the interactive (electronic) entertainment sector. Chart I-11US Overspend On Games, Toys, And Hobbies Is $45 Bn Chart I-12Spending On Pets Is ##br##Booming Pulling all of this together, we expect the $140 billion surplus on durables to disappear fully, and the $280 billion surplus on nondurables to fade to well below $200 billion. Therefore, given that the deficit on services is likely to be above $200 billion, there is a high risk of a consumer demand deficit in 2022. Four Investment Conclusions The ultra-long end of the bond market is figuring out that without sustained above-trend demand, you cannot get sustained inflation. And to repeat, if demand is barely on trend after an unprecedented largesse of fiscal and monetary stimulus, then what will happen when the stimulus ends? All of which leads to four investment conclusions: Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Gas Distribution Is Oversold Finally, one of the paradoxes of skyrocketing natural gas prices is that it has badly hurt the gas distributors which, for the most part, have not been able to pass on the higher prices in full to end users. The resulting margin squeeze has caused a sharp recent underperformance, which is now fragile on its 65-day/130-day composite fractal structure (Chart I-13). Chart I-13Gas Distribution Is Oversold Given this fractal fragility combined with the recent correction in natural gas prices, a recommended trade would be to overweight global gas distribution versus banks, setting a profit target and symmetrical stop-loss at 5 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 I-3Indicators To Watch - Bond Yields ##br##- Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Highlights Bank of Canada: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Bank of England: Markets have aggressively shifted UK interest rate expectations, with a rate hike now expected before year-end. We expect that outcome to occur, but the vote will be close. Stay underweight UK Gilts in global bond portfolios. Maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Feature Chart of the WeekAn Inflation Shock For Bond Yields Steadily climbing inflation expectations, fueled by rising energy prices and persistent supply-chain disruptions, remain a thorn in the side of global bond markets. 10-year US TIPS breakevens have climbed to a 15-year high of 2.7%, while breakevens on 10-year German inflation-linked bonds are at a 9-year high of 2%. Rising inflation expectations are keeping upward pressure on nominal bond yields in the major developed economies, as markets start to slowly reprice the pace and timing of future interest rate increases (Chart of the Week). Market expectations on interest rates, however, can adjust much more quickly when policymakers change their tune. We have already seen that recently in smaller countries like Norway and New Zealand. Rate hikes delivered by the Norges Bank and Reserve Bank of New Zealand over the past month - which were telegraphed well in advance by the central banks – were a negative shock that pushed up bond yields in those countries. The next central bank “liftoff” within the developed economies is expected to occur in the UK and Canada, according to pricing in overnight index swap (OIS) curves (Table 1). In this report, we consider the outlook for monetary policy and government bond yields in both countries, which represent two of our highest conviction underweight recommendations. Table 1Markets Are Pulling Forward Rate Hikes Canada: Watch For A Bond Bearish Policy Shift In Canada, given the economic backdrop and policy constraints, we believe the Bank of Canada (BoC) will have to deliver on the hawkish market-implied path for interest rates, which calls for an initial rate hike to occur in Q2/2022 – much sooner than the central bank’s current messaging on liftoff. Chart 2ACanadian Inflation Not Looking So "Transitory" Anymore First on the BoC’s mind is inflation. Canadian CPI inflation came in at 4.4% year-over-year in September, blowing through analyst expectations and hitting an 18-year high (Charts 2A and 2B). The CPI-trim, a measure of core inflation which strips out extreme price movements, hit 3.4% year-over-year, the highest reading since 1991. All eight major components of the CPI rose on a yearly basis. On an annualized monthly basis, the energy-driven Transportation aggregate declined and less volatile components like Shelter (+1.1%) and Clothing (+0.7%) led the pack in terms of their contribution to the overall figure.   The data show that inflationary pressures are clearly broadening out in the Great White North, no longer constrained to “transitory” sectors. The effect of this inflationary pressure is also starting to make its mark on consumer and business sentiment. Chart 3Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment According to the BoC Survey of Consumer Expectations, the 1-year-ahead forecast of inflation reached a series high of 3.7% in Q3/2021 (Chart 3). While longer-term inflation expectations are more subdued, that doesn’t mean that inflation is not a worry for the Canadian consumer. With inflation expected to run much higher than expected wage growth (+2%) over the next year, consumers expect a decline in their real purchasing power. Correspondingly, consumer confidence is taking a hit—the Bloomberg/Nanos consumer sentiment index has fallen 7.3 points since the July peak. Canadian businesses are much more upbeat. The overall summary indicator from the BoC’s Business Outlook Survey for Q3/2021 climbed to the highest level in the 18-year history of the series (Chart 4). Firms reported continued expectations of strong demand, but with capacity constraints starting to weigh on sales - a quarter of firms surveyed reporting that a lack of capacity and skills will have a negative impact on sales over the next twelve months. In response, more companies are planning on increasing capital expenditure and hiring over the next year (Chart 4, middle panel). More than half of firms surveyed by the BoC indicated that investment spending will be higher over the next two years compared to typical pre-pandemic levels. Chart 4Canadian Businesses Are Brushing Up Against Capacity Constraints However, hiring plans will likely face difficulty, given the large share of firms (64%), reporting more intense labor shortages (Chart 4, bottom panel). A net 50% of respondents now expect wage growth to accelerate over the coming year, driven by a need to attract and retain workers amid strong labor demand. With regards to inflation, the BoC Business Outlook Survey measures the share of respondents that expect inflation over the next two years to fall within four different ranges—below 1%, between 1% and 2%, between 2% and 3%, and above 3% (Chart 5). We can “back out” a point estimate of expected inflation for Canadian firms by assigning a specific level to each of these ranges – 0.5, 1.5%, 2.5%, and 3.5%, respectively – and using the shares of respondents to calculate a weighted average expected inflation rate for the next two years.1 Based on this estimate, Canadian business inflation expectations have bounced rapidly since the 2020 trough and are now at all-time highs. The BoC has already begun to respond to the normalization of the economy and rising inflationary pressures indicated by its business survey by tapering the pace of its bond buying program. The Bank is now targeting weekly bond purchases of C$2bn, down from C$5bn at the start of the program and with another reduction expected at this week’s policy meeting (Chart 6). The size of the balance sheet has also fallen in absolute terms, driven by the Bank drawing down its holdings of treasury bills to virtually zero while also ending pandemic emergency liquidity programs. Chart 5Putting A Number To Canadian Business Inflation Expectations Chart 6The BoC Is Moving Towards Normalizing Policy The BoC now owns a massive 36.5% of Canadian government bonds outstanding – a share acquired in a very short time for this pandemic-era stimulus program. Thus, tapering now is not only necessary from a forward guidance perspective, signaling an eventual shift to less accommodative monetary policy and rate hikes, but also to ensure liquidity in the Canadian sovereign bond market. The remaining BoC tapering will be fairly quick, setting up the more important shift to the timing of the first rate increase. The Canadian OIS curve is currently pricing in BoC liftoff in April 2022, ahead of the BoC’s current guidance of a likely rate hike in the second half of the year (Chart 7). Given the developments on the inflation front, we are inclined to side with the market’s assessment of an earlier hike. In the longer run, rates might even be able to rise further than discounted in swap curves. The real policy rate, calculated as the policy rate minus the BoC’s CPI-trim measure, is negative and a significant distance from the New York Fed’s Q2/2020 estimate of the natural real rate of interest (R-star) for Canada of 1.4%. Admittedly, those estimates have not been updated by the New York Fed for over a year, given the uncertainties over trend growth and output gap measurement created by the pandemic shock. The BoC’s own estimates for the neutral nominal policy interest rate - last updated in April 2021 and therefore inclusive of any structural impacts of the pandemic on potential growth - range from 1.75% to 2.75%.2 The OIS forward curve expects the BoC to only lift rates to 2% in the next hiking cycle, barely in the lower end of the BoC’s neutral range of estimates. After subtracting the mid-point of the BoC’s 1-3% inflation target, presumably a level of inflation consistent with a neutral policy rate, the BoC’s implied real policy rate range is -0.25% to +0.75%. The current level of the real policy rate is near the bottom of that range. Thus, real rates, and the real bond yields that track them over time, have room to rise if the BoC begins to hike rates at a faster pace, and to a higher level, than the market expects. We see this as a likely outcome given the extent of the Canadian inflation overshoot and the robust optimism evident in Canadian business sentiment, thus justifying our current negative view on Canadian government bonds. To think about this mix of rising inflation expectations and increased BoC hawkishness down the road, and its implication for the Canadian inflation-linked bond market, we turn to our Canadian comprehensive breakeven indicator (Chart 8). This indicator combines three measures, on an equal-weighted and standardized basis, to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and the midpoint of the BoC’s 1-3% target inflation, and the gap between market-based and survey-based measures of inflation expectations. Going forward, we will be using the Canadian Business Outlook Survey measure of inflation expectations, introduced in Chart 5, for this indicator. Chart 8Upgrade Canadian Inflation-Linked Bonds To Neutral Two out of three measures point towards Canadian breakevens having further upside. Firstly, they are cheap under our fair value model, where the rise in breakevens has lagged the yearly growth in oil prices. Secondly, breakevens are a long distance away from the survey-based business inflation expectations. However, both forces are more than counteracted with Canadian headline inflation nearly two standard deviations from the BoC’s target, which indicates that the central bank must step in to address high realized inflation. Given these diverging signals on the upside potential for breakevens, we see a neutral allocation to Canadian linkers as more appropriate for the time being Bottom Line: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Will The BoE Actually Hike By December? Chart 9UK Gilts Have Been Hammered By BoE Hawkishness We downgraded our recommended stance on UK government bonds to underweight on August 11 and, since then, Gilts have severely underperformed their developed market peers (Chart 9).3 We had anticipated that the Bank of England (BoE) would be forced to shift their policy guidance in a less dovish direction because of rising UK inflation expectations. Yet we have been surprised by how quickly the BoE has shifted to an open discussion about the potential for imminent interest rate hikes. The BoE’s new chief economist, Huw Pill, commented in the Financial Times last week that UK inflation will likely hit, or even exceed, 5% by early next year, and that the November 4 Monetary Policy Committee (MPC) was “live” with regards to a potential rate hike.4 This followed BoE Governor Andrew Bailey’s comment that the Bank “will have to act” to contain rising inflation expectations. Mixed signals on economic momentum are not making the BoE’s decisions any easier. The preliminary October Markit PMIs ticked higher for both manufacturing and services, but remain below the peak seen last May. At the same time, UK consumer confidence has fallen since August, thanks in part to rapidly rising inflation that has reduced the perceived real buying power of UK consumers. High Inflation Might Last Longer Chart 10Why The BoE Is More Worried About Inflation The BoE’s last set of economic forecasts, published in August, called for headline inflation to temporarily climb to 4% by year-end, before gradually returning to the central bank’s 2% target level in 2022. Yet the BoE’s newfound nervousness over inflation is well-founded, for a number of reasons (Chart 10): The domestic economic recovery has led to a robust labor market, with job vacancies relative to unemployment fully recovering to pre-COVID levels. The 3-month moving average of wage growth remains elevated at 6.9%, although the BoE believes some of that increase could be due to compositional issues related to the pandemic. The BoE is projecting that the UK output gap is narrowing rapidly and would be fully closed in the second half of 2022. This suggests growing underlying inflation pressures were already in place before the latest boost to inflation from global supply-chain disruptions. UK energy costs are soaring, particularly for natural gas which remains the main source for UK electricity production. UK natural gas inventories are the lowest within Europe, yet the supply response from major providers has been slow to develop – most notably, Russia, which is seeking regulatory approval to begin shipping gas through the Nord Stream 2 pipeline. While natural gas prices have stopped rising, for now, inadequate supplies during an expected cold UK winter could keep the upward pressure on UK inflation from energy. UK house price inflation remains well supported, even with the recent expiration of the stamp duty reductions initiated as a form of pandemic economic stimulus. According to the Royal Institution of Chartered Surveyors (RICS), the ratio of UK home sales to inventories is still quite elevated (bottom panel). Given a still-favorable demand/supply balance, and low borrowing costs, UK house price inflation will likely not cool as much as the BoE would prefer to see. Stay Defensive On UK Rates Exposure The combination of rising UK inflation and increasingly hawkish BoE comments has resulted in a rapid upward repricing of UK interest rate expectations over the past few months (Chart 11). Markets now expect the BoE to raise Bank Rate to 1%, from the current 0.1%, by late 2022. More interesting is what is discounted after that. The OIS curve is pricing in no additional rate increases in 2023 and a rate cut in 2024. In other words, the market now believes that the BoE is about to embark on a policy mistake with rate hikes that will need to be quickly reversed. Chart 11Markets Are Pricing In A BoE Policy Error We think there is a risk of a more aggressive-than-expected BoE tightening cycle. The surge in UK inflation expectations is not trivial nor “transitory”. Looking at survey-based measures of expectations like the YouGov/Citigroup survey, or market-based measures like CPI swaps, inflation is expected to reach at least 4% both in the short-term and over the longer-run (Chart 12). If Bank Rate were to peak at a mere 1%, as indicated in the OIS curve, that would still leave UK real interest rates in deeply negative territory even if there was a pullback in inflation expectations. We expect the votes on whether to hike rates at either the November or December MPC meetings to be close. There will be a new Monetary Policy Report published for the November 4 meeting, which will include a new set of economic and inflation forecasts that will give the BoE a platform to signal, or deliver, a rate hike. In the end, we think that the senior leadership on the MPC has already revealed too much of its hawkish hand, and a rate hike will occur by year-end. Looking beyond liftoff into 2022, we still see markets pricing in too shallow a path for Bank Rate over the next couple of years, leaving us comfortable to maintain our underweight stance on UK Gilts. With regards to positioning along the Gilt yield curve, however, we see the potential for more curve steepening even if after the BoE begins to lift rates. The implied path for UK real interest rates, taken as the gap between the UK OIS forwards and CPI swap forwards, shows that markets expect the BoE to keep policy rates well below expected inflation for well into the next decade (Chart 13). At the same time, the wide current gap between the actual real policy rate (Bank Rate minus headline inflation) and the New York Fed’s most recent estimate of the UK neutral real rate (r-star) suggests that the Gilt curve is far too flat (bottom panel). Chart 12The BoE Cannot Ignore This Perversely, this creates a situation where the UK curve steepeners can be an attractive near-term hedge to an underweight stance on UK Gilts. If the BoE does not deliver on the strongly hinted rate hike in November or December, the Gilt curve can steepen as shorter-maturity Gilt yields fall but longer-dated yields remain boosted by high inflation expectations.However, if the BoE does hike and more tightening is signaled, longer-term yields will likely rise more than shorter-term yields as the market prices in a higher future trajectory for policy rates. Bottom Line: Stay underweight UK Gilts in global bond portfolios, but maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 For this calculation, we exclude firms that did not provide a response to the BoC Business Outlook Survey. 2 The Bank of Canada’s Staff Analytical Note on neutral rate estimation can be found here: https://www.bankofcanada.ca/2021/04/staff-analytical-note-2021-6/ 3 Please see BCA Research Global Fixed Income Strategy and European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. 4https://www.ft.com/content/bce7b1c5-0272-480f-8630-85c477e7d69 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 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

Next week is the BCA Annual Conference, at which I will debate Professor Nouriel Roubini on ‘The Outlook For Cryptocurrencies’. I will make the passioned case for cryptos, and Nouriel will make the passioned case against. I do hope that many of you can join the debate, as well as the other insightful sessions at the conference. As such, there will be no report next week and we will be back on October 28. Highlights The anomaly of the current ‘inflation crisis’ is not that goods and commodity prices have surged. The anomaly is that state intervention protected services prices from a massive (and continuing) negative demand shock. Absent the state intervention, there would not be the current ‘inflation crisis’. On a 6-12-month horizon: Underweight the durables-heavy consumer discretionary sector versus the market. Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Fractal analysis: Natural gas, plus industrial metals versus industrial metal equities. Feature Chart of the WeekServices Prices Suffered In The Post-GFC Services Slump... Chart of the Week...But Not In The Post-Pandemic Services Slump. Why Not? The great writers, artists, and musicians tell us that the most profound messages often come from what is not said, not painted, and not played. What does not happen is sometimes more significant than what does happen. In this vein, we believe that the real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. The real story is that while goods and commodity prices have reacted exactly as would be expected to a positive demand shock, services prices have not reacted as would be expected to the mirror-image negative demand shock. The Anomaly Is Not Goods Prices, It Is Services Prices The following analysis quantifies the impact of the pandemic on different parts of the economy by examining the deviations of current spending and prices from their pre-pandemic trends. The analysis uses US data simply because of its timeliness and granularity, but the broad patterns and conclusions apply equally to most other developed economies. Looking at the overall economy, we know that, thus far, we have experienced neither a lasting negative demand shock from the pandemic, nor a lasting positive demand shock from the ensuing stimulus. We know this, because current spending is not far short of its pre-pandemic trend. The real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. Yet when we drill down to the components of spending, we see a different story. The pandemic and its policy response unleashed a massive and unprecedented displacement of spending from services to goods (Chart I-2). Chart I-2The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods By March 2021, while US spending on services was still below its pre-pandemic trend by $700 billion, or 8 percent, the displacement of those dollars of spending had boosted spending on the smaller durable goods component by 26 percent. Suffice to say, a 26 percent excess demand for durable goods cannot be satisfied by a modern manufacturing sector that utilises just-in-time supply chains and negligible spare capacity! As surging demand met relatively fixed supply, the price of durable goods skyrocketed to the current 11 percent above its pre-pandemic trend (Chart I-3). Chart I-3The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational It follows that the inflation in durables prices is the perfectly rational outcome of a classic positive demand shock – meaning, surging demand in the face of limited supply. What is much less rational is that a massive negative demand shock for services has had almost no negative impact on services prices. This is the untold story of the current ‘inflation crisis’ which requires further explanation. Government Intervention Prevented A Collapse In Services Prices If the pandemic had unleashed a classic negative demand shock for services, then services prices would have collapsed. We know this because in the aftermath of the global financial crisis (GFC), services prices fell below their pre-GFC trend exactly in line with the decline in services demand. But in the aftermath of the pandemic’s massive negative shock for services spending, services prices have remained on their pre-pandemic trend (Chart of the Week). The question is, how? The answer is that this was not a classic negative demand shock. The reason that service spending collapsed was that a large swathe of services – such as leisure and hospitality – became unavailable because of mandated shutdowns or lockdowns. In this case, there was no point in reducing prices to reattract demand from durable goods because nobody could buy these services anyway! In effect, while the goods sector remained subject to market forces, a large swathe of the service sector came under state intervention, and was no longer subject to market forces. Meanwhile, statisticians continued to record the seemingly unaffected price of eating out or going to the theatre, even though most restaurants and entertainment venues were shuttered, making their prices meaningless. Absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. Absent state intervention, these service providers would have had to reduce their prices to attract wary consumers amid a pandemic. This we know from Sweden, the one major economy that did not have any mandated shutdowns or lockdowns. While leisure and hospitality have remained largely open, Sweden’s services prices have declined markedly from their pre-pandemic trend – in sharp contrast to the unchanged trend in the US (Chart I-4). Chart I-4Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Hence, while inflation now stands at a sedate 2 percent in Sweden, it stands at a hot 5 percent in the US. If the US (and other country) governments had not intervened in the services sector, then the evidence from the GFC in 2008 and Sweden today strongly suggests that services prices would be below their pre-pandemic trend, offsetting goods prices that are above their pre-pandemic trend. The result would be that the overall price level would be on, or close to, its pre-pandemic trend. Just as overall spending is on its pre-pandemic trend. To repeat the key message of this analysis, the anomaly in most economies is not that goods and commodity prices have surged. The price surge is the perfectly rational response to a positive demand shock. The anomaly is that services prices did not react negatively to a negative demand shock (Chart I-5 and Chart I-6), as they did post-GFC and post-pandemic in non-interventionist Sweden. Chart I-5The Anomaly Is Not That Goods Prices ##br##Rose... Chart I-6...The Anomaly Is That Services Prices Did Not Fall The untold story is that, absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. What Happens Next? The surging demand for durables is correcting. Since March, it is already down by 15 percent but requires a further 7 percent decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own! Meanwhile, as manufacturers respond with a lag to recent high prices, expect a tsunami of durables supply to hit in 6-12 months just as demand has fallen off a cliff. The result will be a major threat to any durable good or commodity price that has not already corrected. As a salutary warning of what lies ahead, witness the recent 75 percent crash in lumber prices. The same principle applies to non-durables such as food and energy. Non-durables spending is likely to fall back to its pre-pandemic trend, and non-durables prices are likely to follow. Again, outside a short-lived surge in demand from, say, a very cold winter, there is only so much energy and food that you can consume. For services, there are two opposing forces. The inflationary force is that the recent inflation in goods will transmit into wages and therefore into services prices. Against this, the deflationary force is that structural changes, such as hybrid home/office working, mean that services spending will struggle to make the near 6 percent increase to reach its pre-pandemic trend. Underweight the durables-heavy consumer discretionary sector versus the market. Pulling these effects together, we reiterate three investment recommendations on a 6-12 month horizon: Underweight the durables-heavy consumer discretionary sector versus the market (Chart I-7). Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Chart I-7As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms Natural Gas Prices Are Technically Extreme The surge in natural gas prices in both Europe and the US has reached a point of extreme fragility on its 130-day fractal structure. Hence, if the tight fundamentals show the slightest signs of abating, natural gas prices would be vulnerable to a sharp reversal (Chart I-8). Chart I-8Natural Gas Prices Are Technically Extreme Elsewhere, we see an arbitrage opportunity between industrial metal prices, which are still close to highs, and industrial metal equities, which have plunged by 20 percent since May. The relationship between the underlying metal prices and the metals equities sector is now stretched versus its history, and on its composite 65/130-day fractal structure (Chart I-9). Chart I-9The Relationship Between Metal Prices And Metal Equities Is Stretched Hence, the recommended trade is to go short the LMEX Index/ long nonferrous metals equities. One way to implement the long side of the pair is through the ETF PICK. Set the profit target and symmetrical stop-loss at 8 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area 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