Base Metals & Iron Ore

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Executive Summary Oil Remains A Prominent Inflation Variable WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations Tight oil and metals markets will translate into persistently high inflation and inflation expectations over the next 5 – 10 years. High and volatile commodity prices caused by low capex will keep global inventories tight for years.  This will keep the key 5-year/5-year (5y5y) CPI swap rates used by policy makers elevated, given the strong relationship between commodity prices – particularly longer-dated oil prices – and inflation expectations. Central banks will exacerbate this tightness if they follow through on more aggressive policy.  This would increase the cost of capital for commodity producers and could induce a recession.  All the same, commodity supplies still will remain tight, and will keep inflationary pressures emanating from the real economy elevated.  Stagflation is the likely outcome. Gold is lagging as an inflation hedge vs. the average return of our commodity recommendations.  We expect this to persist.  Still, as a safe-haven and store of value during recessionary and inflationary periods, we continue to recommend gold as a portfolio hedge. Bottom Line: The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years.  We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. Feature That's all well and good in practice, but how does it work in theory? - Seen on a T-shirt at the University of Chicago1 Related Report  Commodity & Energy StrategyCommodities' Watershed Moment   Central banks are signaling they expect higher inflation and inflation expectations to persist, and now are communicating their collective resolve to deal with this aggressively, if needs be.2 As central-bank policy evolves, commodities – particularly oil – will become even more important as coincident and leading indicators used to assess the likely course of inflation and inflation expectations, particularly their persistence. The ECB notes oil prices have become more than just one of the input costs of manufacturing, or of mining, agriculture and the production of other forms of energy essential to powering modern economies, and delivering these goods globally. For the ECB, "oil is barometer of global economic activity as well as a financial asset."3 Likewise, the BIS stresses the importance of augmenting conventional Phillips curve models with commodity inputs to more accurately capture inflation dynamics.4 This Special Report follows our earlier report published on March 10, 2022 entitled Commodities' Watershed Moment. Here we explore the consequences of tightening commodity markets, especially as regards inflation and inflation expectations, and attempt to dispel some notions about commodities and markets that could lead to policy errors. We also evaluate our commodity recommendations' performance as inflation hedges compared to gold's performance. Modeling Inflation And Inflation Expectations Our own research and modeling broadly aligns with the ECB and BIS approaches. We periodically estimate cointegrating regressions of inflation expectations using WTI futures prices to forecast 5y5y CPI swap rates (Chart 1).5 Our results are strongest when we use 3-years forward WTI prices to forecast 5y5y CPI swap rates, but shorter-term futures also provide useful information and are cointegrated with inflation expectations discovered in the 5y5y market (Chart 2). The prompt-delivery WTI futures are cointegrated with the longer-dated 3-years forward futures contract, indicating that, over time, these different maturities are following a common long-term trend. This also explains why a similar equilibrium obtains using commodity indexes – the Bloomberg Commodity Index, the S&P GSCI, etc. – as regressors in estimating inflation expectations via the 5y5y CPI swap rates. Chart 1WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations Chart 2US Oil Output Slightly Higher US Oil Output Slightly Higher US Oil Output Slightly Higher Globalization of production, distribution and consumption across markets weaves these markets together – e.g., global fertilizer markets experienced a supply shock this past winter when large consuming markets in Asia and Europe got into a bidding war for limited LNG supplies – and transmits shocks across commodity markets. This partly explains the common long-term trend commodities generally share. Another feature weaving markets together globally is the fact that most global trade is invoiced and funded in USD, which means that the Fed's monetary policy decisions reverberate around the world when rates are increased or dollar liquidity is reduced.6 Lastly, trading markets are global. Commodity markets have evolved – as the ECB notes – into asset markets as well as hedging markets. This means arbitrage across commodity and rates markets (interest rates, inflation rates, FX rates, etc.) accelerates the impounding of information into prices quickly. In this environment, cointegration is strengthened among physical and financial trading markets, creating prices that share long-term equilibria. This makes the current time especially fraught, as the Fed embarks on a policy-tightening course against the backdrop of war in Europe and global commodity shortages. These effects are experienced across geographies and across time, forming a dynamic system in which supply, demand and inventories are constantly adjusting to new information. This affects current and expected fundamentals and financial conditions, which arrives to markets instantaneously. It is not surprising, then, that prices in these markets are, for the most part, cointegrated over the long run.7 Policy Errors Likely On The Way Monetary policy is not well suited to dealing with commodity scarcity. Nor is fiscal policy – e.g., government subsidies to soften the blow of rising energy prices only encourage over-consumption of scarce resources, which accelerates inventory depletion and tightens markets further. The Fed, in particular, likely is reviewing its 1970s playbook for lessons learned in the last major supply shock to hit the world – the Arab Oil Embargo of 1973, which was followed by the Iran-Iraq war in 1979. Together, these events triggered a surge in real oil prices, which rose by 4.5x – from $21.55/bbl in 1970 to $116.11/bbl in 1980, according to the EIA (Chart 3). Chart 3Fed Will Look Back At 1970s Playbook Tight Commodity Markets: Persistently High Inflation Tight Commodity Markets: Persistently High Inflation In setting policy, economists generally – at the Fed, the IMF, the World Bank and elsewhere – mistakenly view commodity forward curves as something of a forecast.8 This use of the futures curve is mistaken because it only reflects the price levels as which transactions occurred on any given day. So while a non-specialist might view a backwardated forward curve for Brent as a market-based forecast for lower prices in the future – since prompt prices are trading below deferred prices – a more accurate reading would suggest markets are tight and likely will remain tight. This particular term structure indicates physical inventories are tight, and will remain so until sufficient supply is brought to market to allow refiners to restock. Steep backwardations also predispose markets to higher price volatility, because because of low inventory levels: The market's shock absorber (inventories) is low, so volatility increases.9 Suppose policy makers are counting on lower oil prices – per a forward curve's "forecast" – to bring inflation down. In that case, they likely will be disappointed unless additional supplies arrive. Should the Fed act on the belief that backwardation is a forecast for lower prices and continue to provide forward guidance to markets suggesting inflation will be lower next year, e.g., any delay in its rate hikes will leave it behind the inflation curve. Additional policy errors can come from the fiscal side, for example, when governments provide subsidies to soften the blow of higher oil prices. This retards the function of the price mechanism, and incentivizes higher consumption, which will exacerbate price increases. This would be bullish for oil prices in the short and medium term (6 months – 2 years). Commodity markets are tight globally – at or near scarcity levels in many cases, as can be seen by the continually declining inventories in oil and base metals (Chart 4 and 5). Base metals markets are extremely tight, and are on the back foot – i.e., with physical deficits and low inventories – just as the world's largest economic blocks (EU, US, China) are launching massive buildouts of their renewable-generation fleets and electric grids, and embarking on massive military buildups. These applications will require huge increases in base metals supplies to pull off. Grain markets will tighten as the impact of the Russian invasion of Ukraine unfolds in the spring, when winter wheat crops in Ukraine will need to be fertilized and tended. Chart 4Oil Markets Remain Tight... Oil Markets Remain Tight... Oil Markets Remain Tight... Chart 5…As Do Metals Tight Commodity Markets: Persistently High Inflation Tight Commodity Markets: Persistently High Inflation Barring an extremely deep recession that sharply reduces aggregate demand globally, it is difficult to see how this is not inflationary for years to come. Nonetheless, even a deep recession will still leave markets massively short base metals, and, after core-OPEC producers Saudi Arabia and the UAE bring what left of their spare capacity to market, oil. Investment Implications In days gone by, gold served as a go-to inflation hedge. At present, gold is lagging as an inflation hedge vs. the average return of our direct and equity-related commodity recommendations (Chart 6). We expect this to persist. Gold has performed well against the broad-trade weighted USD, however (Chart 7). We continue to recommend gold as a portfolio hedge, as it remains responsive to policy and geopolitical shocks. And it remains a safe-haven and store of value during recessionary and inflationary periods. Chart 6Commodity Recommendations Outperform Gold Commodity Recommendations Outperform Gold Commodity Recommendations Outperform Gold Chart 7Gold Outperforms USD Gold Outperforms USD Gold Outperforms USD The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years, barring a steep recession. Such a turn of events diminishes in probability, as governments keep funneling subsidies to households to soften the blow of higher prices and stave off a recessionary contraction in GDP. These subsidies only succeed in retarding the price signal the market is sending to reduce consumption of scarce commodities, which means available inventories will be drawn down more quickly. We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. These are long-term holdings, given our view the commodities bull market will run for years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see That Works Very Well in Practice, But How Does It Work In Theory? Published by quoteinvestigator.com for a history of how this phrase made it to UChicago's T-shirts. 2     Please see Between A Rock And A Hard Place, published 21 March 2022 by our US Investment Strategy, which is led by Doug Peta, a UChicago alum. 3    For insight into how central banks assess inflation and inflation expectations vis-à-vis commodity markets, particularly oil, please see the ECB's September 2020 working paper entitled " Global financial markets and oil price shocks in real time," by Fabrizio Venditti, Giovanni Veronese.  In it, the authors note, "The role that the price of oil plays in economic analysis in central banks and in financial markets has evolved over time. Oil is not seen anymore just as a (sic) input to production but also as a barometer of global economic activity as well as a financial asset."   4    The BIS recently noted augmenting standard Phillips Curve models with information from commodities and FX markets to reflect the profound changes wrought by globalization is critical for improving inflation forecasts, and explaining the dynamics of inflation and inflation expectations. Please see "Has globalization changed the inflation process?" by Kristin J. Forbes, published by the Bank for International Settlements in June 2019.  She notes, "The results in this paper suggest it is necessary to incorporate additional “global” factors in models of inflation dynamics, including global slack, non-fuel commodity prices (as well as oil prices), the exchange rate, and global price competition" to accurately explain and forecast inflation.  See below for further discussion. 5    In our modeling, the regressor with the best fit in our 5y5y CPI swap forecasts is the WTI 3-years forward futures contract. Both the 5y5y CPI swap rate and the WTI futures are non-stationary variables sharing a common long-term trend, meaning these are cointegrated random variables. The time series we use start in 2010, so post-GFC, which was a regime change for markets globally. The regression diagnostics are very strong, particularly for the ARDL model. We also find the 3-years forward WTI price is cointegrated with the prompt WTI futures contract, indicating these variables – one calling for delivery of crude oil in 3 years, the other in one month – are cointegrated. We get similar cointegration results using commodity indexes – e.g., the Bloomberg Commodity Index, and the LME base metals index – which tend to use futures contracts closer to delivery. This indicates commodity prices generally can be thought of as non-stationary variables vibrating randomly around a common long-term trend. We use cointegration models to avoid spurious relationships – e.g., regressing a stationary variable on a non-stationary variable. Statistically, cointegration is much stronger than simple correlation because it avoids the trap of spurious relationships. Please see Granger, C.W.J., Developments in the Study of Cointegrated Variables, Chapter 4 in Engle and Granger (eds): 1991, Long-Run Economic Relationships. Readings in Cointegration, Oxford University Press. This is an a article by Clive Granger, who received the Nobel prize in economics in 2003 for his pioneering work developing the mathematics of cointegration. See also Geman, H. (2007), Mean reversion versus random walk in oil and natural gas prices, in Advances in Mathematical Finance (pp. 219-228), for a rigorous discussion of random-walking oil and gas variables. 6    Please see Global Dimensions of U.S. Monetary Policy by Maurice Obstfeld, which appeared in the February 2020 issue of International Journal of Central Banking for an excellent discussion of the Fed's role in global trade. This is not all a one-way street, as Obstfeld notes, in that policy decisions can create "potential spillback onto the U.S. economy from the disproportionate influence of U.S. monetary policy on the outside world." 7     These cointegrating features of commodity markets, inflation rates and USD effects are not agreed by all economists. See, e.g., the Oxford Institute for Energy Studies report of August 2021 Is the Oil Price-Inflation Relationship Transitory? by Ilia Bouchouev. The paper notes, "In theory, the fundamental relationship that exists between short-term inflation and gasoline futures should be fading away with time, and for 5y5y breakeven it should indeed be close to zero. In practice, however, it is not." 8    Please see Forecasting the price of oil, which was published by the ECB in Issue 4 of its 2015. The Bank notes, "Oil price futures are frequently used as the baseline for oil price assumptions in economic projections. They are used, for example, in the Eurosystem/ECB staff macroeconomic projections and in the projections of many other central banks and international institutions. The main reason for using futures as a baseline for oil price assumptions is that they provide a simple and transparent method which is easy to communicate." (p. 90) 9    Please see Kogan, Leonid, Dmitry Livdan and Amir Yaron (2009), " Oil Futures Prices in a Production Economy With Investment Constraints," The Journal of Finance, 64:3, pp. 1345-1375.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Executive Summary Tight Inventories Spike Metals Commodities' Watershed Moment Commodities' Watershed Moment Russia's war against Ukraine is a watershed moment, which will realign production, distribution and consumption of commodities globally. The development of new sources of the critical metals desperately needed to build out renewable energy grids and the drive to secure access to oil, gas and coal will intensify along political lines. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Local politics will intrude on this process, as left-of-center governments in important commodity-producing states secure their electoral victories and claim greater shares of commodity revenues. The rebuilding of defense systems, particularly in Europe, will compete with the renewable-energy transition. This will stress already-tight metals markets, where low inventories will predispose markets to higher volatility a la this week's oil, natgas and nickel price spikes. This will retard economic growth. In the short term, CO2 emissions will surge. Longer term, the transition to net-zero carbon emissions by 2050 will be pushed back years, as states compete for access to commodities. East-West trade restrictions and hoarding of commodities secured via trade within these respective blocs, as is occurring presently, will increase. Bottom Line: Russia's war against Ukraine is a watershed moment.  The development of new sources of the critical metals desperately needed to build out renewable energy grids, and the drive to secure access to oil, gas and coal will intensify. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Feature Russia's war with Ukraine provoked a watershed moment for Europe: Leaders suddenly realized they had to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy generation and grid. This occurred as inventories of the basic commodities required to achieve all of these objectives were stretched so tight that the mere threat of the cutoff of pipeline natural gas was enough to send benchmark EU natgas prices to a record $113/MMBtu, up nearly 80% from the previous day's close before it settled back to still-elevated levels (Chart 1). Oil inventories also were stretched extremely thin even before Russia launched its invasion of Ukraine 24 February (Chart 2). The situation is not improving, since, in the wake of the Ukraine war, numerous refiners and trading companies now are observing self-imposed sanctions against taking any Russian oil or refined products. It is worthwhile remembering this began before the US and UK announced they would ban all imports of Russian material this week.1 This will stretch supply chains by unknow durations – the movement of crude from Russia to a refiner could take months instead of weeks, until new trade patterns are established. Chart 1Little Flex In EU Gas Inventories Commodities' Watershed Moment Commodities' Watershed Moment Chart 2Little Flex In EU Gas Inventories Little Flex In EU Gas Inventories Little Flex In EU Gas Inventories   Global economic and policy uncertainty is massively elevated, with percent changes in oil and gas prices swinging on a double-digit basis daily. This makes it extremely difficult to bid or offer oil cargoes in the physical market or make markets (i.e., bid or offer) in the futures markets, which has the effect of compounding uncertainty and volatility. Fundamentals – supply, demand and inventories – take a back seat to fear and uncertainty in such markets. This makes it virtually impossible to assign a probability to any price outcomes based on supply and demand – the true definition of uncertainty in the Frank Knight sense – and to make long-term capex decisions over the long term.2 We raised our 2022 and 2023 Brent forecasts on the back of the massive uncertainty in the markets to $90/bbl and $85/bbl, respectively, right after Russia's invasion of Ukraine. We assume 1Q22 Brent will average $100/bbl. We expect core OPEC 2.0 producers – Saudi Arabia, UAE and Kuwait – will increase production beginning in 2Q22; US shale-oil output will rise, and ~ 1.2mm b/d of Iranian production will return to market in 2H22. Among the risks to our forecasts are a failure by core OPEC 2.0 to lift output (we expect an announcement at the end of this month when the producer coalition meets); lower-than-expected US shale output, and a failure to resolve the Iran nuclear deal with the US. Our modeling indicated these outcomes could lift Brent to between $120/bbl and $140/bbl by 2023 (Chart 3). We will be updating our forecasts next week.3 Chart 3Brent Forwards Lift Brent Forwards Lift Brent Forwards Lift EU's Watershed Metals Moment EU leadership is setting out to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy grid, all a result of the Ukraine war. This will require massive investment in metals mining and refining, along with steel-making capacity. Already, Germany is pledging to increase LNG import capacity and measures to reduce its dependence on Russian natural gas by 75% this year.4 The EU is looking to restore its natgas inventories to 90% of capacity before next winter, and has pledged to double down on renewables, in order to remove member-state dependence on Russian energy exports.5 These ambitious goals are up against the hard reality of scarce base metals supply globally. This will be exacerbated going forward by actions taken by and against Russia. The Russia-Ukraine crisis will destabilize metal markets, given supply uncertainty from Russia and its contribution to global supply. The commodities heavyweight constitutes 6%, 5% and 4% of global primary aluminum, refined nickel and copper production. Against the backdrop of very low global inventories in these metals (Chart 4), the prices of all three hit record highs over the last few days due to uncertain supply (Chart 5). LME nickel prices more than quadrupled on Tuesday as traders rushed to cover short positions and margin calls. Chart 4Low Inventories... Low Inventories... Low Inventories... Chart 5...Lead To Price Volatility ...Lead To Price Volatility ...Lead To Price Volatility Uncertainty has engulfed metal markets, with a Western ban on Russian metal imports still a possibility. Putin’s announcement regarding raw material export restrictions will further fuel supply uncertainty.6 As in the case of oil, private entities’ self-sanctioning, sanctions on the Russian financial system, and war-related supply chain disruptions are causing current Russian metal export disruptions.7 So far, Western sanctions on commodities have not directly interfered with metal flows from Russia. But markets are taking it day to day. Supply disruptions and sanctions force the formation of new trade patterns, as private entities aim to maximize arbitrage opportunities. For example, high European aluminum price spreads incentivized shipments from China, the world’s largest producer and consumer of refined aluminum. Normally, Europe relies on Russia for aluminum supplies. Rising European physical premiums for delivered metal, caused by Russian export disruptions, will see trading companies take advantage of arbitrage opportunities in other commodities as well. Europe's Risk Profile Rising Since the Ukraine war began, rising European physical premiums in commodities ranging from metals to natgas indicate the continent – more so than others – is particularly vulnerable to Russian export disruptions. Europe’s reliance on Russian energy and its supply disruptions will raise operating costs for smelters and refiners on the continent, threatening smelter shutdowns similar to those we saw this past winter. Markets were expecting power price relief over the warmer months and higher smelting activity. Elevated fuel and power prices, however, will constrain metals refining in Europe, and could shut or close even more smelters, keeping refined metals supply scarce and prices high. Rebuilding Europe's Defenses EU leaders are scheduled to take up a new energy and defense funding proposal today, which media reports are describing as "massive" (no detail provided ahead of the meeting, of course). This program reportedly will be akin to the EU's $2 trillion COVID-relief fund.8 The EU's fast response to defense shortfalls comes against the backdrop discussed above regarding super-tight metals markets, which now face a further complication of unpredictable local politics in metals-producing states. Some of these states have voted left-of-center governments into office, which now appear to be intent on nationalizing mining operations.9 Chile, e.g., accounts for ~ 30% of global copper ore output, and is in the process of re-writing its constitution, which will change tax and royalty law, and could pave the way for nationalization of copper and lithium mines. This political risk compounds any long-term planning operations by consumers like the EU and producers. Investment Implications Energy markets – broadly defined to include oil, gas and coal along with the base metals required for renewables and their supporting grids and electric vehicles – are being rocked by Russia's war with Ukraine. Base metals, in particular, will have to find price levels that destroy demand among competing uses, if the EU's dual-track plan to build out its renewables generation and restore a military capability is approved. A "massive" funding effort in Europe, coupled with equally massive efforts in the US and China – both intent on building out their renewable generation and grids, as well as expanding their defensive capabilities – will be extremely difficult to pull off. Critical base metals inventories remain low, and prices are high because demand exceeds supply for the foreseeable future (Chart 6). Chart 6Tight Inventories Spike Metals Commodities' Watershed Moment Commodities' Watershed Moment The EU will join a world in which the other two great economic centers – the US and China – will engage in a geopolitical competition over access to and control of scarce base metals, oil, gas and coal resources. Russia will remain aggressive toward the West, at least until the Putin regime falls, and will play an ancillary role to China. Fossil fuels and base metals have been starved for capex for more than a decade. Governmental pronouncements will not reverse this. These markets will remain tight, and will get tighter in order to allocate increasingly scarce supply with rapidly growing demand. As such, we remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF, and the XME and PICK ETFs to retain exposure to base metals and bulks producers and traders.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Footnotes 1     Please see Russian tankers at sea despite ‘big unknown’ over who will buy oil, published by ft.com on March 7, 2022. 2     Please see Explained: Knightian uncertainty, published by mit.edu for discussion. 3    Please see Oil Risk Premium Abates, But Still Remains, which we published on February 25, 2022. 4    Please see Germany Revives LNG Import Plans to Cut Reliance on Russian Natural Gas in Marked Policy Shift, published by naturalgasintel.com on March 1, 2022. 5    Please see Climate change: EU unveils plan to end reliance on Russian gas, published by bbc.co.uk on March 8, 2022, and The EU plan to drastically ramp renewables to replace Russian gas, published by pv-magazine.com on March 9, 2022. 6    Please see Russia to Omit Raw Material Exports but Omits Details, published by Bloomberg on March 9, 2022. 7     Please see here for Which companies have stopped doing business with Russia? 8    Please see Ukraine: ECB governing council to meet as crisis intensifies, published on March 8, 2022 by greencentralbanking.com. 9    Please see Chile a step closer to nationalizing copper and lithium, published by mining.com on March 7, 2022, and Add Local Politics To Copper Supply Risks, which we published on November 25, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Executive Summary Euro Natgas Soars; LME Nickel Squeezed Euro Natgas, Nickel Soar Euro Natgas, Nickel Soar Russian Energy Minister Alexander Novak's threat to halt shipmentsof natgas on Nord Stream 1 to Europe lifted European gas prices 25% overnight, and will reverberate for years. We make the odds of a cut-off of Russian natgas exports to the EU low but not extremely low. Russia’s war is about the status of Ukraine. Russia needs the EU markets, and the EU needs Russia's gas. However, if Russia follows through on Novak's threat, it would be a major disruption for gas markets in the short term. Over the medium to long term, US shale gas producers, LNG terminal operators and exporters will benefit from new demand. On the import side, China likely benefits most from Russia's need to re-route gas. But this will require substantial infrastructure investment to monetize Russia's gas supplies and as such will take years to realize. Separately, the LME has shut down its nickel markets following an explosive 250% rally over two days that took prices above $100,000/MT. Nickel settled at ~ $80,000/MT before the LME closed the market today for margin calls on shorts squeezed by the surge in prices to make margin calls. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. We also remain long the XME and PICK ETFs to retain exposure to base metals and bulks.

Executive Summary Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? The Russia/Ukraine conflict is impacting financial markets across numerous channels – uncertainty, risk aversion, growth expectations & inflation expectations – but all have a common link through soaring commodity prices, most notably for oil. For global bond investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. We recommend investors maintain neutral allocations to inflation-linked bonds versus nominal government bonds across the developed world until there is greater clarity on future global oil production. Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries. Bottom Line: The supply premium on global oil prices will persist until there are signs of more global oil production or less chaos in the Ukraine – neither of which is imminent. Maintain neutral allocations to inflation-linked bonds versus nominal government debt across the developed markets. Feature Chart 1A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices The Russia/Ukraine war has sent an inflationary shock though the world through a very traditional source – rising commodity prices. Energy prices are getting most of the attention, with oil prices back to levels last seen in 2008 and US gasoline prices now above $4 per gallon. The commodity rally is not just in energy, though. Industrial metals prices have also gone up substantially, with the spot prices for copper and aluminum hitting an all-time-high and 16-year-high, respectively (Chart 1). Agricultural commodities have seen even larger increases, with the price of wheat up 22% and the price of corn up 11% since the Russian invasion began on February 24th. Europe is acutely exposed to the war-driven spike in energy prices given its reliance on Russia for natural gas supplies. Natural gas prices in Europe have spiked a staggering 117% since the invasion started, exacerbating a sharp demand/supply imbalance dating back to the reopening of Europe’s economy from COVID lockdowns one year ago (Chart 2). To date, booming energy prices have fueled a huge rise in headline inflation rates in the euro area – producer prices were up 31% on a year-over-year basis in January – but with little trickle down to core inflation which was only up 2.3% in January. High energy prices are not only a problem for global growth and inflation, but also for the future policy moves by central banks. Inflation rates boosted over the past year by commodity supply squeezes and supply chain disruptions were set to decline this year, but the Ukraine shock has thrown that into question. If the benchmark Brent oil price were to hit $150/bbl, this would end the decelerating trend for energy price inflation momentum, on a year-over-year basis, that has been in place since mid-2021 (Chart 3). That means a higher floor for the energy component of inflation indices, and thus overall headline inflation rates, throughout the major economies in the coming months. Chart 2Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem ​​​​​ Chart 3Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? ​​​​​ Chart 4The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs How will bond markets respond to higher-than-expected inflation? Rate hike expectations have been highly correlated to the trend of headline inflation in the US, Europe, UK, Canada and Australia over the past year (Chart 4). Currently, overnight index swap (OIS) curves are still discounting between 5-6 rate hikes from the Fed, the Bank of England, the Bank of Canada and the Reserve Bank of Australia before the end of 2022. A single rate hike is still priced into the European OIS curve, even with the Ukraine shock. Global bond yields have been volatile, but surprisingly resilient despite the worries about war and commodity inflation. The 10-year Treasury yield has been trading in a range between 1.7% and 2% since the Russian offensive began, while the 10-year German Bund yield has hovered around 0%. Bond markets are pricing in a stagflation-type outcome of slowing growth and rising inflation, as multiple rate hikes are still discounted despite the geopolitical risks from the war. That reduces the value of using increased duration exposure to position for risk-off moves in a bond portfolio. At the same time, real bond yields are falling and breakeven rates are rising for global inflation-linked bonds – a part of the fixed income universe that looks to offer good protection against the uncertainties of war. Inflation-Linked Bonds – A Good Hedge Against War Risks Since the Russian invasion began, breakeven inflation rates on 10-year inflation-linked bonds have moved higher in the US (+13bps), Canada (+19bps), Australia (+15bps) and even Japan (+15bps). The moves have been even more significant on the European continent – 10-year breakevens have shot up in the UK (+23bps), Germany (+45bps), France (+31bps) and Italy (+36bps). Chart 5Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe The absolute levels of breakevens in Europe are high in the context of recent history (Chart 5). However, breakevens also look a bit stretched in other countries like the US. Our preferred metric to evaluate the upside potential for inflation-linked bonds is our Comprehensive Breakeven Indicators (CBI). The CBI for each country is comprised of three components: the deviation of 10-year breakevens from our model-implied fair value, the spread between 10-year breakevens and longer-term survey-based inflation expectations (the “inflation risk premium”) and the gap between actual inflation and the central bank inflation target. Those three components are all standardized and added together with equal weights to come up with the CBI. A higher CBI reading suggests less potential for inflation breakevens to widen, and vice versa. Currently, the CBIs for the eight countries in our Model Bond Portfolio universe are close to or above zero, suggesting more limited scope for breakevens to widen further (Chart 6). Only in Canada is the CBI below zero, and only slightly so as high realized Canadian inflation is offset by breakevens trading below both fair value and survey-based measures of inflation (Chart 7). Chart 6Global Inflation Breakeven Valuations Are Not That Cheap A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors In the US, the CBI is above zero mostly because of high realized US inflation. In Europe, the CBIs of the UK, Germany and Italy all are well above zero, while in France the CBI is close to zero. The UK has the highest CBI in our eight-country universe, with all three components contributing roughly equally (Chart 8). The Japanese CBI is also just above the zero line. Chart 7Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations ​​​​​​ Chart 8European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock ​​​​​​ We have been recommending a relative cautious allocation to global breakeven bonds in recent months. We saw the upside potential on breakevens as capped given the dearth of “cheap” signals on breakevens from our CBIs, especially with central banks moving towards monetary tightening in response to elevated inflation – moves intended to restore inflation-fighting credibility with bond markets. Yet the Ukraine commodity shock has boosted inflation breakevens even in countries with modest underlying (non-commodity) inflation like Japan and the euro area. We now see greater value in owning inflation-linked bonds in global bond portfolios as a hedge against the inflation risks stemming from the Ukraine and the worsening geopolitical tensions between the West and Russia. This is true even without the typical positive signal for breakevens from having CBIs below zero. We recommend that fixed income investors maintain a neutral allocation to inflation-linked bonds in dedicated government bond portfolios across the entire developed market “linker” universe. In our model bond portfolio, we had been allocating to linkers based off the signal from the CBIs, but in the current stagflationary war environment, we see country allocations as secondary to having neutral exposure to linkers in all countries. The new weightings to inflation-linked bonds are shown in the model bond portfolio tables on pages 12-14.1 Bottom Line: For global fixed income investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. Canada Update: BoC Liftoff At Last The Bank of Canada (BoC) raised its policy interest rate by 25bps to 0.5% last week, commencing the start of the first rate hike cycle since 2018. The move was no surprise after BoC Governor Tiff Macklem signaled at the January monetary policy meeting that the start of a rate hiking cycle was imminent. The Canadian Overnight Index Swap (OIS) curve is discounting another 171bps of hikes in 2022, with a peak rate of 1.98% reached by March 2023 - near the low-end of the BoC’s range of neutral rate estimates between 1.75% and 2.75% (Chart 9). Chart 9Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation The BoC noted that the Canadian economy was recovering faster than expected from the effects of the Omicron variant and the associated restrictions on activity, coming off a robust 6.7% annualized real GDP growth rate in Q4/2021. The BoC now estimates that economic slack created by the pandemic shock has been fully absorbed, with the unemployment rate at 6.5%. Canadian headline inflation reached a 32-year high of 5.1% in January (Chart 10) – a level that Governor Macklem bluntly called “too high” in a speech the day following the rate hike. The BoC’s CPI-trim measure that excludes the most volatile components is also at an elevated reading of 4%, suggesting that the higher inflation is broad based. The BoC sees persistent high inflation as a risk to the stability of medium-term inflation expectations, thus justifying tighter monetary policy. According the latest BoC Survey of Consumer Expectations, Canadians expect inflation to be 4.1% over the next two years and 3.5% over the next five years, both of which are above the BoC’s 1-3% inflation target band. So with a robust economy, tight labor market, inflation well above the BoC target and elevated consumer inflation expectations showing no signs of settling, why is the OIS curve discounting such a relatively low peak in the BoC policy rate? The answer lies with Canada’s housing bubble and the associated high household debt levels. In a recent Special Report, our colleagues at The Bank Credit Analyst estimated that the neutral rate in Canada was no higher than 1.75%- the previous peak in rates during the 2017-2018 tightening cycle. A big reason for that was the high level of Canadian household debt, which now sits at 180% of disposable income. This compares to the equivalent measure in the US of 124%, showing that unlike their southern neighbors, Canadian households had little appetite for deleveraging after the 2008 financial crisis (Chart 11). Chart 10Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC ​​​​​​ Chart 11A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC ​​​​​​ Chart 12Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads The Bank Credit Analyst report estimated that if the BoC hiked rates to 2.5% over the next two years – just below the high end of the BoC neutral range – the Canadian household debt service ratio would climb to a new high of 15.5% (bottom panel). This would greatly restrict Canadian consumer spending and likely trigger a sharp pullback in both housing demand and real estate prices. The conclusion: the neutral interest rate in Canada is likely closer to the peak seen during the previous 2018/19 hiking cycle around 1.75%. We have been recommending an underweight stance on Canadian government bonds in global fixed income portfolios dating back to the spring of 2021. However, with markets now discounting a peak in rates within plausible estimates of neutral, the window for additional underperformance of Canadian government bonds may be closing - but not equally versus all developed economies. We have found that a useful leading indicator of 10-year cross-country government bond yield spreads is the differential between our 24-month discounters. The discounters measure the cumulative amount of short-term interest rate increases over the next two years priced into OIS curves. Currently the “discounter gaps” are signaling room for Canadian spread widening versus the UK and Japan and, to a lesser extent, core Europe (Chart 12). However, the discounter gap is pointing to significant potential for narrowing of the Canada-US 10-year spread over the next year (top panel). This would occur even if the BoC follows the Fed with rate hikes in 2022, as the Fed is likely to deliver more increases in 2023/24 than the BoC. This week, we are introducing two new recommended positions to benefit from narrower Canada-US government bond spreads: We are reducing the size of our underweight position in our model bond portfolio in half, offset by a reduction in the allocation to US Treasuries (see the table on page 13). We are introducing a new trade in our Tactical Overlay, going long Canadian 10-year government bond futures versus selling 10-year US Treasury futures on a duration-matched basis (the specific details of the trade can be found in the table on page 15) We are maintaining our cyclical underweight recommendation on Canada, in a global bond portfolio context, given the potential for Canadian yield spreads to widen versus core Europe, Japan and the UK. That underweight recommendation will be more concentrated versus countries relative to the US. Bottom Line: Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The allocations to inflation-linked bonds shown in the model bond portfolio reflect both the recommended country weights and the recommended weighting of linkers versus nominal bonds within each country.  For example, we are neutral US TIPS versus nominal bonds within the US Treasury component of the portfolio, but since we are also underweight the US as a country allocation, the TIPS allocation is below the custom benchmark index weight. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors Tactical Overlay Trades

Executive Summary Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Copper Will Grind Higher Copper Will Grind Higher Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Copper Will Grind Higher Copper Will Grind Higher Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Copper Will Grind Higher Copper Will Grind Higher Chart 6Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Copper Will Grind Higher Copper Will Grind Higher Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher Copper Continues To Grid Higher Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Copper Will Grind Higher Copper Will Grind Higher Chart 10 Bitcoin Price Aligns With Gold Price And S&P 500 INDEX Bitcoin Price Aligns With Gold Price And S&P 500 INDEX     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast series ‘Where Is The Groupthink Wrong?' I do hope you can join. Executive Summary Spending on goods is in freefall while spending on services is struggling to regain its pre-pandemic trend.  If spending on goods crashes to below its previous trend, then there will be a substantial shortfall in demand. The good news is that the freefall in goods spending is leading inflation. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year. Underweight the goods-dominated consumer discretionary sector, and underweight semiconductors versus the broader technology sector. Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Overbought base metals are particularly vulnerable. Fractal trading watchlist: We focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Bottom Line: As spending on goods crashes back to earth, so will inflation, consumer discretionary stocks, semiconductors, and overbought commodities. Feature The pandemic has unleashed a great experiment in our spending behaviour. After a binge on consumer goods, will there be a massive hangover? We are about to find out. The pandemic binge on consumer goods, peaking in the US at a 26 percent overspend, is unprecedented in modern economic history. Hence, we cannot be certain what happens next, but there are three possibilities: We sustain the binge on goods, at least partly. Spending on goods falls back to its pre-pandemic trend. There is a hangover, in which spending on goods crashes to below its previous trend. The answer to this question will have a huge bearing on growth and inflation in 2022-23. After The Binge Comes The Hangover… The pandemic’s constraints on socialising, movement, and in-person contact caused a slump in spending on many services: recreation, hospitality, travel, in-person shopping, and in-person healthcare. Nevertheless, with incomes propped up by massive stimulus, we displaced our spending to items that could be enjoyed within the pandemic’s confines; namely, goods – on which, we binged (Chart I-1). Chart I-1Spending On Goods Is In Freefall Spending On Goods Is In Freefall Spending On Goods Is In Freefall Gradually, we learned to live with SARS-CoV-2, and spending on services bounced back. At the same time, we made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping. Additionally, a significant minority of people changed their behaviour, shunning activities that require close contact with strangers – going to the cinema or to amusement parks, using public transport, or going to the dentist or in-person doctors’ appointments. The result is that spending on services is levelling off well short of its pre-pandemic trend (Charts I-2-Chart I-5). Chart I-2Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Chart I-3Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Chart I-4Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Chart I-5Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Arithmetically therefore, to keep overall demand on trend, spending on goods must stay above its pre-pandemic trend. Yet spending on goods is crashing back to earth. The simple reason is that durables, by their very definition, are durable. Even nondurables such as clothes and shoes are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can binge on before reaching saturation. Indeed, to the extent that our bingeing has brought forward future purchases, the big risk is a period of underspending on goods. Countering The Counterarguments Let’s address some counterarguments to the hangover thesis. One counterargument is that some goods are a substitute for services: for example, eating-in (food at home) substitutes for eating-out; and recreational goods substitute for recreational services. So, if there is a shortfall in services spending, there will be an automatic substitution into goods spending. The problem is that the substitutes are not mirror-image substitutes. Spending on eating-in tends to be much less than on eating-out. And once you have bought your recreational goods, you don’t keep buying them! A second counterargument is that provided the savings rate does not rise, there will be no shortfall in spending. Yet this is a tautology. The savings rate is simply the residual of income less spending. So, to the extent that there is a structural shortfall in services spending combined with a hangover in goods spending, the savings rate must rise – as it has in the past two months. A third counterargument is that the war chest of savings accumulated during the pandemic will unleash a tsunami of spending. Well, it hasn’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-6). Chart I-6Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending The explanation comes from a theory known as Mental Accounting Bias. This points out that we segment our money into different ‘mental accounts’. And that the main factor that establishes whether we spend our money is which mental account it resides in. The moment we move money from our ‘income’ account into our ‘wealth’ account, our propensity to spend it collapses. Specifically, we will spend most of the money in our ‘income’ mental account, but we will spend little of the money in our ‘wealth’ mental account. Hence, the moment we move money from our income account into our wealth account, our propensity to spend it collapses. Still, this brings us to a fourth counterargument, which claims that even though the ‘wealth effect’ is small, it isn’t zero. Therefore, the recent boom in household wealth will bolster growth. Yet as we explained in The Wealth Impulse Has Peaked, the impact of your wealth on your spending growth does not come from your wealth change. It comes from your wealth impulse, which is fading fast (Chart I-7). Chart I-7The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked Analogous to the more widely-used credit impulse, the wealth impulse compares your capital gain in any year with your capital gain in the preceding year. It is this change in your capital gain – and not the capital gain per se – that establishes the growth in your ‘wealth effect’ spending. Unfortunately, the wealth impulse has peaked, meaning its impact on spending growth will not be a tailwind. It will be a headwind. As Spending On Goods Crashes Back To Earth, So Will Inflation, Consumer Discretionary Stocks, And Overbought Commodities In the fourth quarter of 2021, US consumer spending dipped to below its pre-pandemic trend and the savings rate increased. Begging the question, how did the US economy manage to grow at a stellar 6.7 percent (annualised) rate? The simple answer is that inventory restocking contributed almost 5 percent to the 6.7 percent growth rate. In fact, removing inventory restocking, US final demand came to a virtual standstill in the second half of 2021, growing at just a 1 percent (annualised) rate. Growth that is dependent on inventory restocking is a concern because inventory restocking averages to zero in the long run, and after a massive positive contribution there tends to come a symmetrical negative contribution. If, as we expect, spending on services fails to catch up to its pre-pandemic trend while spending on goods falls back to its pre-pandemic trend, then there will be a demand shortfall. And if there is a hangover, in which spending on goods crashes to below its previous trend, then the demand shortfall could be substantial. As inflation crashes back to earth, so will overbought commodities. The good news is that the freefall in durable goods spending is leading inflation. In this regard, you might be surprised to learn that the US core (6-month) inflation rate has already been declining for five consecutive months. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year (Chart I-8). Chart I-8As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Given that the level (rather than the inflation) of commodity prices is irrationally tracking the inflation rate, the likely explanation is that investors have piled into commodities as a hedge against inflation. Hence, as inflation crashes back to earth, so will overbought commodities (Chart I-9). Overbought base metals are particularly vulnerable. Chart I-9Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Fractal Trading Watchlist This week we focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. To reiterate, overbought base metals are vulnerable, and the 70 percent outperformance of nickel versus silver through the past year has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2016, 2018, and 2020 (Chart I-10). Accordingly, this week’s recommended trade is to go short nickel versus silver, setting the profit target and symmetrical stop-loss at 20 percent.  Chart I-10Short Nickel Versus Silver Short Nickel Versus Silver Short Nickel Versus Silver A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell EUR/CZK At A Bottom EUR/CZK At A Bottom EUR/CZK At A Bottom Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations      

Highlights The faster-than-expected oil-demand recovery from the COVID-19 omicron variant points to higher EM trade volumes this year and next, which, along with a weaker USD, will boost base-metals demand and prices (Chart of the Week). The recovery in iron-ore prices on the back of China stimulus and omicron-induced labor shortages at miners will lift copper prices, the base-metals' bellwether.  Supply-demand balances in refined copper showed a physical deficit of 438K MT for the January-October 2021 period, indicating the market extended its years-long deficit in 2021. Despite the IMF's mark-down in global growth due to slowdowns in the US and China this year, metals demand will continue to exceed supply, which will support prices. Short squeezes – most recently in nickel, following a headline-grabbing copper squeeze in October – will keep base metals' inventories under pressure and forward curves backwardated. We remain long the S&P GSCI and the COMT ETF, as well as the PICK ETF, to remain exposed to backwardation.  At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off. We are raising our 2022 copper target to $5.00/lb on COMEX, and keeping our 2023 expectation at $6.00/lb. Feature Inadequate development in new base metals supply, which has been apparent for years, means economic recovery and expansion will continue to tax existing supplies over the short run (to end-2023).1  Chart of the WeekExpected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Chart 2Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... At a global level, prolonged supply-demand imbalances mean inventories will continue to be drawn hard to cover for prompt supply shortfalls.  This can be seen in the principal base metals we cover: copper (Chart 2), aluminum (Chart 3), nickel (Chart 4), and zinc (Chart 5).  As a result, short squeezes in base metals markets will continue to grab headlines, as persistent physical deficits periodically drain inventories.2   Longer term, the global effort to decarbonize energy supply could be stretched out well beyond 2050, when most policymakers assume the task of replacing fossil-fuel energy sources will largely be completed.  The longer it takes to mobilize capex, the more expensive the energy transition becomes, as markets are continually forced to adjust to short-term shortages leading to price spikes and squeezes in an effort to meet demand. Chart 3...Aluminum... ...Aluminum... ...Aluminum... Chart 4...Nickel... ...Nickel... ...Nickel... Chart 5...And Zinc. ...And Zinc. ...And Zinc. Faster Demand Recovery In Metals Faster-than-expected oil-demand recovery will translate to higher trade volumes globally this year and next.  This is particularly important for EM markets, given oil and metals prices – particularly copper, the base metals bellwether – share a common long-term equilibrium (i.e., they're cointegrated, as seen in the Chart of the Week).3 A pick-up in EM trade volumes, along with a weakening USD this year, will help lift copper prices.  Most trade is in manufactured goods, which will translate into a pick-up in cyclical stocks vs. defensive stocks as well, which also is supportive of copper prices (Chart 6). Copper prices also will be supported by the recovery in iron-ore prices, which have been bid up on the back of increasing stimulus in China and global growth ex-China, as well as omicron-induced labor shortages among miners.  As is typical, copper demand will follow in the wake of steel demand, as construction and infrastructure projects are finished off (i.e., plumbing and wiring are installed) (Chart 7). Chart 6Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Chart 7Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Supply Side Remains Challenged Impressive gains put up on the supply side last year in Indonesia – which, according to the International Copper Study Group, posted a 51% increase in copper output at the Grasberg mine over the first 10 months of 2021, – and other smaller producers notwithstanding, geopolitical uncertainty continues to dominate the supply-side risks to base metals generally, copper in particular.4 Economic and political uncertainty in Chile and Peru, which account for 30% and 10% of global copper output, respectively, will continue to keep miners hesitant in their capex allocations, in our view.  Both states have elected left-of-center governments, which still are working through how they will deliver on their election mandates, including revenue re-distribution, taxation and royalties.5 The combination of stronger demand and tepid supply growth will keep base metals inventories under pressure, which will translate into continued backwardation.  This is particularly apparent in the copper (Chart 8) and nickel (Chart 9).  Both of these squeezes resulted from buyers treating the London Metal Exchange as a supplier of last resort – which is an extremely rare occurrence in futures markets – and both required the intervention of the London Metal Exchange to address.6 Chart 8Copper Backwardation Will Persist Copper Backwardation Will Persist Copper Backwardation Will Persist Chart 9...As Will Nickels ...As Will Nickels ...As Will Nickels Investment Implications Base metals markets will continue to find it difficult to match supply with demand, as they have for the past several years.  This further compounds the global energy transition – largely because the suppliers of the metals needed to pull it off are starting from a deep physical deficit position – and likely delays it considerably. In an environment in which obstacles to developing the supply needed to phase out fossil fuels in favor of renewable generation continue to mount, we remain long commodity index exposure – the S&P GSCI and COMT ETF – and favor exposure to miners and trading companies that are responsible for moving metals around the globe. At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off of 10% for its highs of $47/share.  Our view on base metals is they are a long-term value play, in which miners and the supply side generally, will benefit from the high prices needed to develop the supply the energy transition will require.  The big risk here is these companies once again lose the plot and fail to control costs to produce at the expense of the health of their margins.  If we see this, we will exit the position.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish We expect OPEC 2.0 to announce they'll continue with the return of another 400k b/d at next week's monthly meeting.  In reality, the producer coalition most likely will fail to return these volumes to market and will fall short of the mark again.  The real news markets are waiting for is whether the four states capable of increasing supply and sustaining higher output – Saudi Arabia, Iraq, the UAE and Kuwait – will step up to cover the growing gap between volumes that were pledged and what's actually been delivered.  The coalition agreed in July 2021 to begin returning some of the 5.8mm b/d of output pulled from the market during the COVID-19 pandemic starting in August 2021.  To date, the producer group has fallen short by about 800k b/d, based on the IEA's January 2022 estimates. Failure to increase production by the four core OPEC 2.0 states could keep prices above $90/bbl this year and next (Chart 10). Base Metals: Bullish Iron ore prices have rallied ~ 14% since the start of this year, as markets expect China to ease steel production cuts in 2022 and loosen monetary policy.  Last week, the People’s Bank of China (PBoC) cut its policy interest rate for the first time in nearly two years.  Markets expect more stimulus and policy easing in China as the central bank and government attempt to stimulate an economy mired by COVID-19 lockdowns, a property market slump and high energy prices.  Higher stimulus implies more commodity refining and manufacturing activity, including steel production, which will lead to higher iron ore demand. Precious Metals: Bullish In line with market expectations, the Federal Reserve signaled an initial rate hike in March, in its January Federal Open Market Committee (FOMC) meeting. While nominal interest rates will rise, the Fed will remain behind the inflation curve. The US CPI reading for December showed that inflation was 7% higher year-on-year, the highest annual increase in inflation since 1982 (Chart 11). High inflation and the Fed’s slow start to raise nominal interest rates will keep real rates, the opportunity cost of holding gold, low. Chart 10 Brent Forecast Restored To $80/bbl For 2022 Brent Forecast Restored To $80/bbl For 2022 Chart 11 Short Squeezes In Copper, Nickel Highlight Tight Metals Markets Short Squeezes In Copper, Nickel Highlight Tight Metals Markets     Footnotes 1     Please see 2022 Key Views: Past As Prelude For Commodities, published on December 16, 2021 for additional discussion. 2     Please see Column: Nickel gripped by ferocious squeeze as stocks disappear: Andy Home, published by reuters.com on January 20, 2022; and LME copper spreads backwardated amid stock squeeze, published by argusmedia.com on October 20, 2021. 3    This was flagged most recently in the IEA's January 2022 Oil Market Report, which noted, "While the number of Omicron cases is surging worldwide, oil demand defied expectations in 4Q21, rising by 1.1 mb/d to 99 mb/d. In 1Q22, demand is set for a seasonal decline, exacerbated by more teleworking and less air travel. We have raised our global demand estimates by 200 kb/d for 2021 and 2022 – resulting in growth of 5.5 mb/d and 3.3 mb/d, respectively – due to softer Covid restrictions."  Please see Higher Output Needed To Constrain Oil Prices for our latest oil balances and price forecasts.  We published this report last week. 4    Please see International Copper Study Group press release of January 2022. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021, for a discussion of these risks. 6    Please see Footnote 2 above.     Investment Views and Themes Recommendations Strategic Recommendations Trades Closed In 2021 Image