Equities

Highlights The Seventh National Population Census highlights the seriousness of China’s demographic deterioration; apart from a shrinking working-age population, the nation’s fertility and birth rates have dropped meaningfully. China’s urbanization rate will likely slow in the second half of this decade. The country’s urban population growth is only slightly positive, while the rural population is declining and aging. Demand for housing will experience a structural downshift, particularly in less developed regions.  Competition for labor will become fiercer among regions and sectors, and wage growth will continue to accelerate. However, the manufacturing sector will remain competitive regardless of wage inflation, thanks to the rising quality of China’s labor force and innovation. Interest rates will structurally shift to a lower range, providing some tailwind to Chinese equities and government bonds. Feature The Seventh Population Census, conducted by the National Bureau of Statistics every 10 years, reinforced the magnitude of China’s demographic challenge. The nation’s population is not only aging but is set to start shrinking due to extremely low birth and fertility rates. The main implication is that China’s urbanization rate will slow and property market will likely encounter a structural downshift, tied to declining demand from both its working-age (age 15 to 64) and total population. Demand for housing will increasingly concentrate in top-tier cities because these metropolitan areas have more advantages attracting labor. Secondly, manufacturing will likely maintain its share of GDP, despite China’s push for consumption and growth in the service sector. Importantly, interest rates will continue to shift downward along with a decelerating potential growth; waning interest rates will create a tailwind to China’s capital market in the long term.  Highlights From The Census The Census showed three meaningful shifts in China’s demographics in the past decade:  1.  China is getting old before getting rich. China is experiencing a worse demographic transition than Japan in the early 1990s, with a lower level of per capita wealth than Japan attained when its working-age population peaked (Chart 1). Over the past ten years China’s population has only expanded by 5.4%, the lowest rate since the first census in 1953. Moreover, the country’s oldest cohort rose from 8.9% in 2010 to 13.5% and the working-age population is falling more quickly than in Japan. China’s working-age population peaked in 2010 and then fell by 6.79 percentage points in the next 10 years. In contrast, Japan’s working-age population peaked in 1992 and fell by 2.18 percentage points in the subsequent decade (Chart 1, top panel). 2.  China’s total population is set to start declining in five years. Some demographers project that China’s total population will peak in 2027,1 but a high-level Chinese official recently predicted that the country’s population will start to trend down as early as in 2025.2 The relaxation of the one-child policy in 2015 helped to lift the birthrate (births per 1,000 people) briefly in 2016, before falling sharply again in 2017. The population’s natural growth rate, calculated as birthrate minus deathrate, is rapidly approaching zero (Chart 2). Chart 1China's Working Population Falling Faster Than Japan's In 1990s Chart 2China's Population Growth Will Turn Negative In Mid-2020s The birthrate is the main determinant of the population’s natural growth rate given that China’s deathrate has been steady for decades.  If the birthrate continues to fall at the current rate, then China will undoubtedly reach a population turning point and will join nations such as Japan, Germany and South Korea, which have negative population growth.  3.  A low fertility trap. Chart 3China's Alarmingly Low Fertility Rate Is Set To Decline Even Further... China’s extremely low fertility rate3 is a major contributor to its falling birthrate.  The current 1.3 reading is less than in many developed countries, such as Japan with 1.4 and the US with 1.6, and it is far below the fertility rate of 2.1 needed to stabilize a population, according to the United Nations (Chart 3). China’s fertility rate is set to dive even further in the coming years due to structural factors such as a dwindling number of childbearing-age women linked to the one-child policy implemented in the 1980s (Chart 4). China’s high female labor participation rate and low propensity among young people to get married, and the high cost of raising children in urban areas, all are long-standing socio-economic issues hindering the Chinese from having more babies (Chart 5). Chart 4…Due To Fewer Childbearing-Age Women And… Chart 5...Structural Issues That Curb Chinese Propensity To Produce Babies Bottom Line: These structural trends will take decades to reverse. China faces a dramatic plunge in its population in the very near future if the authorities do not enact significant and immediate policy changes.   Urbanization Pace Will Slow The Census indicates that rapid urbanization continued through 2020, with the rate hitting 64% of the population, up 14 percentage points from 2010. However, the headline number in the urbanization rate understates China’s progress in industrialization, i.e. the country’s rural-to-urban transition has entered a late stage and the current pace cannot be sustained in the future. Significantly, China’s underlying demographic shifts will likely lead to a passive increase in the urbanization rate in the second half of this decade. This trend will curb rather than boost demand in urban areas.  The experience of developed countries suggests that the pace of urbanization begins to slow when the rate reaches around 70% (Chart 6). Based on China’s current level, the country should reach the 70% threshold in just six to seven years. Meanwhile, China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85%, which means that 85% of jobs in China are in non-agricultural sectors (Chart 7). Chart 6Urbanization Progress Stabilizes When Reaching 70% Chart 7China Is Much More Industrialized Than Commonly Believed Furthermore, a higher urbanization reading may be the result of negative natural population growth. Given that the urbanization rate is calculated as a percentage of urban population in the total population, a decline in the absolute level of total population (the denominator) could lead to a passive increase in the numerator. Chart 8Japan Has Had A "Passive" Increase In Urbanization Since 2012 For example, Japan’s urbanization rate rose significantly during the 2000s, and maintained an upward momentum even as its total population peaked in 2010. However, its urban population growth rate dropped dramatically and turned negative in 2012 – suggesting the increase in the urbanization rate is due to a shrinking total population instead of expanding urbanities (Chart 8). The rising deathrate of the rural elderly population is another important reason for the accelerated increase in Japan's urbanization rate. China’s urban population growth is on a sharp down trend, although it is still slightly positive (Chart 9). However, the rural population has shrunk and aged, which limits future migration from rural to urban areas (Chart 10).  China’s rural population has shrunk by almost half from its peak in 1995 to 2020. The share of the rural population 50 years and older doubled in the same period. Chart 9China's Urban Population Growth Is On The Decline... Chart 10...While Rural Population Has Shrunk And Aged Thus, China’s rural-to-urban migration has slowed in the past decade (the trend turned negative last year due to the pandemic). The number of new migrant workers moving from the country to the city tumbled from 12.5 million a year to 2.5 million, and the number of younger migrants (50 years and younger) has contracted since 2017 (Chart 11). Chart 11The Number Of Young Migrant Workers Started Contracting In 2017 Bottom Line: Country-to-city migration will be smaller going forward based on a diminishing rural population, an increasing number of elders and a reduced proportion of young people in rural areas. When China’s population peaks, which is highly likely by 2025, its urbanization progress will turn passive and the aggregate population growth in urban areas may also turn negative. Aggregate Housing Demand Will Dwindle The demographic shifts described above will impact the demand for properties and accentuate regional divergences in housing demand and prices.   Historically, changes in the working-age population led residential home sales by five to six years. Home sales have fluctuated in a downward trend in the past five years along with a peak in the working-age population in 2015 (Chart 12). Moreover, the sharp deterioration in China’s birthrate means that home sales will be significantly reduced in the next 15-20 years. Chart 12Aggregate Demand For Housing Will Dwindle Along With Smaller Labor Force Chart 13Population Is An Important Driver For Urban Development The regional divergence in the demand for housing will also widen. Population, especially the labor force, is an important driver for urban development and housing (Chart 13 above). Population migration mainly occurs among 15-59-year-olds, and this cohort is also the main homeowner group. As China’s labor force increasingly flocks to developed areas, the economic development of less developed areas will face greater challenges (Chart 14). Those areas will encounter a combination of declining birthrate and outflow of labor force. This demographic shift is already evident in many two- and third-tier cities where housing prices have lagged far behind the tier-one cities (Chart 15). Chart 14Less Developed Regions Have Seen Net Population Losses In The Past Decade… Chart 15...And Softening Housing Prices Bottom Line: The drop in China’s birthrate and working-age population will lead to less demand for housing. However, China’s first-tier cities (and core metropolitan areas) will likely continue to outperform third- and fourth-tier cities in terms of labor growth, consumption and home prices. Labor Measures And Manufacturing Competitiveness Labor shortages in selected sectors and upward pressure on wages will likely intensify in the coming decade. While labor quantity will decrease, the quality of China’s labor force will remain competitive. From an aggregate economy perspective, improving labor productivity and automation can help to offset the smaller number of workers (Chart 16). Following two decades of rapid expansion in the industrial sector, China’s labor shortages began to multiply when the country’s urbanization ratio rose to between 50% and 60%. Looking at Japan and Korea, for example, a shortage in manufacturing labor emerged when the countries’ manufacturing/agricultural employment ratio climbed above one. China’s employment ratio likely have crossed this threshold in the mid-2010s, coinciding with a rollover in its working-age population and a massive jump in wage growth (Chart 17). Chart 16Improving Labor Quality To Offset Smaller Labor Quantity Chart 17Manufacturing Labor Shortage And Wage Pressure Intensified In Mid-2010s The manufacturing and service sectors will continue to compete with agriculture for labor. The wage gap between urban and rural areas is disappearing and there are signs of labor market tightness in urban settings (Chart 18).  While the demand for labor has been flat, labor supply peaked in 2013/14 and has been on the wane since that time, which has resulted in an ascending demand-to-supply ratio in China’s urban labor market (Chart 19). Chart 18Wage Gap Between Urban And Rural Areas Is Disappearing Chart 19Urban Labor Supply Can't Keep Up With Demand The bright side is that China’s labor shortage and escalating wages have not eroded the competitiveness of its manufacturing sector. Impressive labor productivity gains and progressively improving labor quality have trumped higher input costs (Chart 20). Consistent with improved productivity, China’s share of global trade continues to build regardless of higher wages, a stronger currency, and import tariffs from the US (Chart 21). The manufacturing sector has gradually climbed the value-added chain in recent years and mounting wage pressures will likely push the corporate sector, particularly in more developed coastal regions, to move further away from a labor-intensive model. Chart 20Rising Wages But Stable Unit Labor Costs Chart 21Chinese Exporters Have Maintained Their Global Market Share Despite Higher Costs The 14th Five-Year Plan outlined policymakers’ decision to maintain the share of manufacturing in GDP, which is around 30%. Labor productivity in the manufacturing sector is notably higher than in the service sector. In an environment of shrinking labor, keeping workers in a high-productivity sector may be a better way to stabilize potential growth. Bottom Line: The competition for labor between sectors will intensify. Meanwhile, manufacturing’s share of China’s economy will likely be sustained in this decade, which will help to mitigate the speed of the deceleration in China’s growth.  Implications On Policy Setting Chart 22AInterest Rates Drop With Aging Population The combination of a weak fertility/birthrate and a decline in the working-age population will weigh on consumption and investment growth, bringing deflationary headwinds to the economy. China’s interest rate regime will likely follow its Asian neighbors to downshift structurally (Chart 22). Despite moderating potential economic growth, a low interest rate environment may be positive for China’s financial asset prices.  Chart 22BInterest Rates Drop With Aging Population Chart 22CInterest Rates Drop With Aging Population Chart 23Support Ratios Are Declining Globally One could argue that a falling support ratio – measured by the number of workers relative to consumers – can lead to inflation (Chart 23). This could happen to the US where baby boomers retire but continue to spend particularly on healthcare, while production falls along with the available workers. As production falls in relation to consumption, inflation could rise. However, this is not the case in China where both production and consumption will fall. Demand from an aging population may increase pockets of inflationary pressures, such as healthcare and elderly care, but it is unlikely to fully offset weakening demand from a declining working-age population and total population. In other words, both the numerator (workers) and denominator (consumers) will be falling in China. While a weakening demographic profile is negative for economic growth, lower prices on capital will make corporate debt-servicing cheaper. Further industrial consolidation aimed at supply-side reforms will also improve corporate profitability. Cheaper capital, improving productivity and efficiency could provide tailwinds to Chinese stocks and government bonds in the long run.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1As of 2020, China’s total population is at 1411.78 million. 2"China faces an economic crisis as a population peak nears," South China Morning Post, April 18, 2021. 3The total fertility rate is based on the number of newborns by women in child-bearing years, which is ages 15-44 or 15-49 by international statistical standards.  Cyclical Investment Stance Equity Sector Recommendations

Highlights The number one risk to our upbeat view on European economic activity and assets is a Chinese economic slowdown. The second most important risk to our view is a potential deterioration in the global credit impulse, even outside of China. The third major risk is that the current bout of US inflation proves to be permanent, which, paradoxically, would prompt a deflationary shock for the global economy. Despite these risks, we maintain our favorable view on European assets over the coming 12 to 18 months. However, favoring industrials over materials, and financials over other cyclicals, Swedish equities and peripheral bonds in balanced portfolios mitigate some of these risks. Do not expect the ECB to announce a tapering of its asset purchases at the June meeting. The ECB will lag well behind the Fed and the BoE. Buy European steepeners and US flatteners as a box trade. Feature Over the past three weeks, a sustained marketing push gave us the opportunity to interact intensively with a large subset of our clients (albeit virtually, courtesy of COVID-19). Generally, our positive stance on European assets was well received, but investors are loosely committing themselves to this view and very few are willing to make an aggressive bet on Europe. In fact, in most meetings, we spent more time than usual discussing the risks to our upbeat view on Europe and European cyclical equities. Three risks to our 12- to 18-month view standout. The first is a serious slowdown in Chinese growth. The second is a greater-than-anticipated impact on economic activity as a result of a deterioration in DM credit impulses. The third is stronger-than-expected US inflation. An also-ran was the risk that the current vaccines do not protect against the two variants of the COVID-19 virus dominant in India. However, an increasing body of recent scientific studies demonstrates that this is not the case; hence, this risk has been lowered to minor. Risk #1: A Chinese Slowdown Authorities in China have been constricting credit policy over the past six months. The key tools used have been a regulatory tightening in shadow-banking activities and real estate transactions, moral suasion on small banks to limit the expansion of their loan books, and slowing liquidity injections in the interbank system. Beijing’s policy tightening reflects the following two worries. First, the financial stability risk has increased meaningfully over the past 16 months. China’s corporate debt-to-GDP has increased 13 points to 163%, and is among the highest for major economies (Chart 1). Moreover, Chinese policymakers remain concerned by the middle-income trap, which would become an increasingly likely outcome if the stability of the country’s financial and banking system were compromised. Second, the latest round of stimulus has worsened wealth inequalities. House prices have been robust, yet household disposable income growth is still low by the yardstick of the past 40 years (Chart 2). Thus, a large proportion of China’s population has experienced a decline in housing affordability. Chart 1China"s Financial Stabilitiy Risk Chart 2Chinese Households Are Not Doing That Well The Chinese economy recently started to feel the impact of the policy tightening. China’s April retail sales data missed expectation by 7.2%, and, as our China Investment Strategy colleagues have observed, the demand side of the economy has lagged behind the recovery in supply ever since China re-opened last year. Credit trends confirm this assessment. The decline in the excess reserve ratio of the Chinese banking system is consistent with the recent deterioration in the credit impulse, which accelerated in April (Chart 3). Since the Great Financial Crisis, weaker Chinese credit flows herald softer global industrial activity and trade (Chart 3, bottom panel). The Chinese slowdown could become a major problem for the European economy and its asset markets. As we recently showed, the sensitivity of European economic activity to global growth has been steadily increasing over the past 20 years (Chart 4). Moreover, the spread between M1 and M2 money supply growth in China best explains the gap between European industrial activity and that of the US (Chart 4, middle and bottom panels). Essentially, M1 minus M2 approximates the Chinese private sector’s marginal propensity to consume, because it captures how fast demand deposits are growing relative to savings deposits. Thus, the recent decline in China’s marginal propensity to consume constitutes a bad omen for European activity and profit growth, both in absolute terms and relative to the US. Chart 3A Policy-Induced Slowdown Chart 4Europe Is More Exposed Than The US The slowdown in China’s economy will hurt European asset prices via multiple channels. Importantly, cyclical stocks are expensive and overbought compared to defensive ones. A meaningful decline in Chinese growth could result in a deep fall in the cyclicals-to-defensives ratio, which would hurt the pro-cyclical EUR/USD exchange rate (Chart 5). A weaker China might also create a significant fall in global yields, because it would hurt global growth, accentuate deflationary forces, and upset investor sentiment. European stocks underperform US equities when global yields decline (Chart 6). Chart 5The Euro Is Pro-Cyclical Chart 6A Key Threat To European Stocks Despite the dire impact that a Chinese economic slowdown normally causes on European growth and assets, this outcome remains a risk and not a base case (albeit, the top risk in our view). First, today is one of the rare occasions when global and European economic activity can decouple from China. The Euro Area’s vaccination campaign is gaining steam, which will allow a re-opening of the economy this summer (Chart 7). The vast pent-up demand in durable goods evident in Europe and the positive impact of the European monetary expansion on the contribution of consumer expenditure to real GDP growth also create powerful offsets (Chart 8). Chart 8European Pent-Up Demand As An Offset Chart 7Improving Vaccine Rollout The global industrial cycle is more buffered than usual against a Chinese economic slowdown. The collapse in the inventory-to-sales ratios around the world will fuel several quarters of restocking, which will boost the global manufacturing sector (Chart 9). Moreover, governments across advanced economies are unleashing large-scale infrastructure plans, such as the $2 trillion bill proposed by the Biden administration in the US or the EUR250 billion budget proposal by the Draghi government in Italy. As the EUR750 billion NGEU funds are disbursed, the tailwind to infrastructure spending will only grow (Chart 10). Additionally, the current spurt in inflation around the world is a relative price shock driven by scarcity created during the pandemic. This price shock incentivizes companies to expand production and capacity to meet demand. As a result, global capex intentions are rising, which will create an additional offset to China. Chart 9Restocking Ahead Chart 10More Fiscal Support This Way Comes Finally, constraints on Chinese policymakers limit to how far Chinese growth will decelerate. The Chinese Communist Party Congress, in which the make-up of the politburo is determined for the next five years, takes place in October 2022. However, the weak growth rate of household disposable income creates a headache for China’s leadership. While another round of massive stimulus is unlikely to shore up household disposable income (it has not worked thus far), Beijing will not take the chance to generate another deflationary shock. This constraint creates a natural floor under the growth deceleration that Beijing can tolerate. Thus, while a policy mistake is still possible, it is not our base case scenario. Investment Implication Faced with the aforementioned dynamics, BCA recommends that investors with a short-term investment horizon go neutral on cyclical equities relative to defensive ones. Practically, this means that EUR/USD is likely to continue to churn between 1.18 and 1.235 for the coming two to three months. Additionally, European equities are likely to move sideways relative to their US counterparts over this period. Within cyclical equities, we favor industrials over materials. Commodity prices, and thus the materials sector, are the most exposed to China. Meanwhile, the outlook for infrastructure spending and capex in DM economies has a greater impact on industrial stocks than on materials ones. Technically, industrials remain toward the bottom of their upward-slopping trend channel relative to materials, which suggests further catch up is likely (Chart 11). We also favor European financials over the rest of the cyclical sectors. The negative impact of a greater-than-expected Chinese economic slowdown on global yields will hurt financials. Nonetheless, domestic economic activity affects financials more than it influences the more internationally focused industrials and materials sectors. Thus, if the Eurozone service PMI can slingshot higher, a result of the re-opening of the economy this summer, then European financials will outperform industrials and materials stocks even if the Chinese economy slows (Chart 12). Moreover, financials trade at a large discount compared to these other two cyclical sectors (Chart 12). Chart 11Overweight Industrials Vs Materials Chart 12Financials As A Protection Against China Finally, we continue to favor Swedish equities. Industrials and financials account for 65% of the Swedish MSCI benchmark compared to 30% for that of the Euro Area. Therefore, they are particularly exposed to the positive outlook on global infrastructure spending and capex. Moreover, Swedish equities generate a return on equity of 15%, compared to 6% for the Eurozone stocks. To protect against the risk created by a weakening Chinese economy, we recommend investors hedge a long / overweight bet on Sweden with a short / underweight position in Norwegian equities that massively over-represent energy and materials. Risk #2: A Global Credit Impulse Deterioration According to the BIS data, the global credit impulse is on the verge of deteriorating, even outside of China. The G10 plus China annual credit impulse is elevated and peaking (Chart 13, left). Meanwhile, quarterly credit impulses in the US, the Euro Area, and China are negative (Chart 13, right), which often leads to turning points in the annual change in credit flows. Chart 13A Global Credit Impulse Problem Chart 13A Global Credit Impulse Problem A deterioration in the credit impulse could result in a sharp slowdown in global economic growth, because the deceleration in credit creation is broad-based among the major economies. If global growth decelerates, then European economic activity will also suffer. Table 1Essential Sector Breakdowns The impact on European financial markets will come from lower yields. A growth deceleration prompted by a falling credit impulse will put downward pressure on yields and will hurt the performance of value stocks relative to growth equities. Cyclical equities will also underperform defensive ones. In this scenario, European stocks will lag behind their US counterparts because of their relative sectoral biases (Table 1). Within the European benchmark, Tech-heavy Dutch stocks would perform best once yields begin to decline. The effect on growth of the slowing credit impulse remains a risk and not a base case scenario. Last year’s surge in credit intake mostly reflected precautionary demand. Companies around the world tapped their credit lines or the capital markets early in the crisis to build liquidity buffers. They then continued to borrow to take advantage of the exceptionally low interest rates that prevailed throughout most of the year. Similarly, a large proportion of household borrowing amounted to debt refinancing. As a result, last year’s explosion in credit growth had a limited impact on spending. Thus, the credit impulse’s decline in advanced economies should minimally hurt aggregate demand in the coming months. Investment Implication Investors can protect against this risk by overweighting Italian and Spanish bonds in a balanced portfolio. First, these instruments continue to offer better value than other government bonds around the world. Moreover, if global growth turns out to be weaker than expected, the ECB might have to increase the envelope of the PEPP program, which has greatly benefited peripheral bonds. Moreover, the NGEU and REACT EU program buttress weaker European sovereign borrowers. Therefore, yield-hungry global investors will resume their aggressive purchase of the high-yielding peripheral bonds if global interest rates decline anew because of softening economic activity. Risk #3: Stronger Than Expected US Inflation BCA’s house view is that the current surge in global and US inflation is transitory, even if the pressures could last a few months before ebbing. It is mainly a consequence of inadequate aggregate supply in the face of a sudden surge in demand. We cannot be dogmatic about the inflation risk. The price-components of all the major activity surveys in the world are rising, and, in the US, the inflation expectations of households have risen meaningfully (Chart 14). If an inflation mentality were to take root, then core CPI would not decelerate toward yearend. Stronger-than-expected US core CPI would put significant upward pressure on Treasury yields. First, long-dated inflation expectations could begin to converge to the breakeven rates in the shorter tenors of the curve (Chart 15). More importantly, the Fed would become more hawkish sooner. This faster policy tightening would lift the OIS curve and result in higher real yields as well. Chart 14Are Inflation Expectations Becoming Unmoored? Chart 15Long-Dated Market-Based Inflation Expectations Still Lag The euro would therefore weaken, and the dollar would rally across the board. European inflationary pressures are limited compared to those of the US. The Eurozone suffers from a larger output gap due to the lagging nature of the European recovery, which more timid fiscal stimulus and Europe’s late start to the vaccination campaign compounded. Consequently, the ECB will not match the Fed’s faster tightening of policy, even in this scenario. Higher US TIPS yields and a stronger dollar would ultimately be deflationary blows to global growth. The dollar would directly tighten EM financial conditions. Higher real yields would destabilize stretched equity prices around the world. The resulting shock to global financial conditions would cause a major slowdown in global growth to occur much earlier than we currently foresee. While yields would rise at first, they would end 2022 at much lower levels than we currently expect because of this deflationary outcome. This combination would be very harmful to European equities, both in absolute terms and relative to the global benchmark. At first, European stocks would probably briefly fare well. Once investors begin to digest the deleterious impact of stronger inflation on global growth, however, the pro-cyclical European market will begin to suffer. Tighter EM financial conditions and underperforming financials will only accentuate the European stock market ills. Much stronger inflation is a risk and not a base case for now, because the current bout of inflation is transitory. The supply-side of the economy is already responding to the signal created by higher prices. Firms are set to increase their inventories and capex intentions are moving higher. Moreover, many of the bottlenecks constraining global supply chains will loosen, as the global economy re-opens in response to the international vaccination campaign. Additionally, current labor shortages in low-wage industry will also dissipate, once the $300 weekly support by the US government ends after the month of September. Thus, the supply of labor will also pick up in the fourth quarter of 2021. Moreover, the Fed could remain tolerant of an inflation overshoot, which would limit the pain of its impact. That being said, there is a real inflation risk due to the global deterioration in the dependency ratio and the shift to the left in terms of the economic preferences of the median voter. However, this danger is backdated to 2024 and beyond, once global labor markets are closer to full employment. Investment Implication There is little protection in our current set of recommendations against this risk, but this is a smaller threat than the previous two risks. However, when viewed alongside the first and second set of risks, the combined probability of a dangerous outcome for the market in general and for Europe in particular has grown compared to six months ago. Thus, while the jury is still out on these questions, it makes sense to de-risk portfolios temporarily, until the reward-to-risk ratio has once again improved. Hence, a tactical neutral stance on cyclical relative to defensive equities and on Europe relative to the rest of the world is appropriate for now. Will The ECB Join The BoC? At its April meeting, the Bank of Canada jolted the market by announcing a much earlier-than-anticipated start to its tapering program. We do not believe that the ECB will follow up at its June meeting. In a recent report, BCA’s Global Fixed-Income Strategy team highlighted the constraint that will prevent the ECB from adjusting policy next month.  The main factors are as follows: The results from the ECB’s strategic review have yet to be announced. Adjusting policy before an eventual change in the inflation mandate of the central banks creates an unnecessary risk of policy whipsaw. Yet another policy flip-flop would further mar the ECB’s credibility. Chart 16The ECB Does Not Want To Upend Credit Growth Loan growth in Europe is slowing down, led by France. However, Italian credit activity is improving in response to the generous TLTRO uptake in the southern economy (Chart 16). At this juncture, a rapid policy adjustment would threaten the recovery, while Europe has yet to re-open. Italian spreads remain fragile. The ECB’s asset purchases are an important contributor to the easing in financial conditions across the periphery. The recent 25bps widening in the BTP-Bund spread is a reminder that European fixed-income markets are not fully tension-free. Thus, a rapid removal of support could prompt a reflex selloff in Italian bonds. The subsequent tightening in financial conditions would unnecessarily feed deflationary pressures in Europe. The euro is strong. If the ECB unsettled the market and removed monetary accommodation as fast or even faster than the Fed, the euro’s rally would suddenly accelerate. This would generate a powerful deflationary shock for Europe that would force the ECB to adjust its inflation forecasts downward. Chart 17Especially When China Creates A Threat The Chinese economy is weak, which increases uncertainty around European economic outcome via the trade channel (Chart 17). Instead, the meetings in the back half of the year are much more likely candidates for the ECB to begin talking about its tapering program. By then, the European economic re-opening will have taken place, to which growth will have responded. The results of the ECB’s strategic reviews will have been announced. Finally, plans will have been ratified for the usage of NGEU funds across the EU, and thus, fiscal clarity will improve. Even if the ECB starts talking before yearend of terminating the PEPP, its communications will indicate that the program’s full envelope will be deployed within the original time frame. Thus, the PEPP program will be in place until the end of March 2022. Moreover, to prevent a rapid deterioration in bank credit, the ECB will continue to provide generous financing to deposit-taking institutions via the TLTRO program. Under these circumstances, the ECB is unlikely to increase its deposit rate before 2014. These views imply that the ECB policy tightening (both on the balance sheet and interest rate fronts) will lag behind that of the Fed, the BoE, the Norges Bank, and the Riksbank. Only the BoJ and the SNB will move after the ECB. The continued involvement of the ECB in the European fixed-income market, along with the elevated likelihood that we remain years away from the first rate hike, confirms that an overweight stance in European peripheral bonds is appropriate. We also continue to overweight corporate credit within European fixed-income portfolios. Our fixed-income colleagues also share these views. Chart 18Justifying A Box Trade Finally, the German yield curve should steepen compared to that of the US. Even if the ECB lags well behind the Fed when it comes to tightening policy, the current terminal rate proxy embedded in the EONIA curve is too low (Chart 18). Meanwhile, the earlier lift-off date for interest rates in the US relative to the Euro Area points to rising short rates west of the Atlantic. In this context, a box trade buying steepeners in Europe and flatteners in the US is appropriate, especially since it generates a positive carry of 167 bps (hedged into USD).   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 Chart I-14The Dollar Usually Weakens In H2 The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

The SPX has been striving to find direction over the past couple of weeks in the seasonally weak month of May, as “transitory inflation” may actually morph into more semi-permanent inflation. The Fed’s latest minutes signaled that tapering is likely on its way, especially if non-farm payrolls resume increasing month-over-month near the one million mark as the economy will be in full reopening mode this Memorial Day. Historically, there is some turbulence that comes with the transition from ultra-easy monetary policy stance to, at the margin, less easy monetary policy warning that a shakeout equity market phase still looms. Tack on the modestly negative signal from investor positioning in the options market (top panel) and a volatile summer is likely upon us. Finally, news of China’s crackdown on cryptocurrencies has taken a bite out of Bitcoin that has been experiencing wild intra-day swings of late. Some of these apparent liquidation pressures have spilled over to the S&P 500 and, given the recent tight positive correlation between Bitcoin and the SPX (bottom panel), warn that some caution is still warranted in the equity space, at least in the near-term.  

Weekly Performance Update For the week ending Thu May 20, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI -0.41% 1.18% Top Contributors   AM:US AMKR:US TXN:US GOOG.L:US NWSA:US Weekly Return 26 bps 19 bps 10 bps 10 bps 9 bps Top Detractors   SCCO:US UHAL:US AN:US UGI:US PII:US Weekly Return -26 bps -17 bps -14 bps -11 bps -11 bps Top Prospects   TX:US UHAL:US ESGR:US SCCO:US AN:US BCA Score 99.58% 98.02% 96.67% 95.30% 93.87% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI 1.71% 2.17% Top Contributors   AUP:CA DCBO:CA NXE:CA NPI:CA NWC:CA Weekly Return 43 bps 32 bps 31 bps 15 bps 15 bps Top Detractors   IFP:CA CFP:CA CS:CA CCA:CA FTT:CA Weekly Return -23 bps -22 bps -9 bps -8 bps -6 bps Top Prospects   CS:CA IFP:CA CFP:CA LNF:CA RUS:CA BCA Score 99.90% 99.70% 98.56% 98.20% 98.13% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 0.99% 0.95% Top Contributors   DRX:GB PLUS:GB PZC:GB TYMN:GB FDEV:GB Weekly Return 35 bps 21 bps 16 bps 12 bps 12 bps Top Detractors   ROSN:GB FXPO:GB CNE:GB TEP:GB SPI:GB Weekly Return -16 bps -14 bps -10 bps -7 bps -6 bps Top Prospects   SVST:GB NLMK:GB TUNE:GB GLTR:GB BPCR:GB BCA Score 99.76% 98.66% 97.58% 96.58% 94.88% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 1.43% 1.32% Top Contributors   VGP:BE KESKOB:FI SOL:IT CNV:FR AOF:DE Weekly Return 23 bps 20 bps 17 bps 14 bps 13 bps Top Detractors   MOL:IT PHH2:DE EDNR:IT STR:AT FSKRS:FI Weekly Return -20 bps -9 bps -8 bps -6 bps -4 bps Top Prospects   SOLV:BE POST:AT STR:AT FSKRS:FI SO:FR BCA Score 99.43% 98.67% 98.00% 97.29% 96.66% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI 2.31% 2.54% Top Contributors   3291:JP 9543:JP 8795:JP 4326:JP 8850:JP Weekly Return 36 bps 35 bps 31 bps 25 bps 22 bps Top Detractors   2791:JP 6458:JP 4839:JP 8133:JP 4708:JP Weekly Return -29 bps -26 bps -22 bps -8 bps -7 bps Top Prospects   6960:JP 4966:JP 1766:JP 9436:JP 3291:JP BCA Score 99.26% 98.18% 97.92% 97.60% 97.41% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI 2.52% 2.81% Top Contributors   990:HK 1830:HK 1600:HK 327:HK 867:HK Weekly Return 56 bps 41 bps 28 bps 28 bps 21 bps Top Detractors   323:HK 1898:HK 316:HK 1606:HK 43:HK Weekly Return -34 bps -16 bps -14 bps -11 bps -6 bps Top Prospects   1606:HK 990:HK 316:HK 323:HK 116:HK BCA Score 99.19% 99.16% 98.80% 98.71% 98.53% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 0.25% 0.67% Top Contributors   ADH:AU HT1:AU PDN:AU BLX:AU FLN:AU Weekly Return 22 bps 18 bps 16 bps 16 bps 14 bps Top Detractors   MGX:AU STX:AU GRR:AU PSQ:AU MVF:AU Weekly Return -27 bps -26 bps -21 bps -16 bps -13 bps Top Prospects   GRR:AU BSE:AU PSQ:AU MGX:AU CAJ:AU BCA Score 99.66% 99.31% 97.84% 95.43% 94.79%

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   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