Bear/Bull Market

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

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. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… The Business Cycle Drives Earnings... The Business Cycle Drives Earnings... Chart 2…Earnings In Turn Drive Stock Prices… ...Earnings In Turn Drive Stock Prices... ...Earnings In Turn Drive Stock Prices... An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns ...Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party A Long House Party A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock The Aging Capital Stock The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright Chart 19Need More Houses Need More Houses Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Mo' Debt Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market Special Trade Recommendations Current MacroQuant Model Scores The Golden Rule For Investing In The Stock Market The Golden Rule For Investing In The Stock Market

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover A Correction Not A Bear Market A Correction Not A Bear Market Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Business Cycles Drive Earnings Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive US Homebuilders Looking Attractive US Homebuilders Looking Attractive 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%. Global Investment Strategy View Matrix A Correction Not A Bear Market A Correction Not A Bear Market Special Trade Recommendations Current MacroQuant Model Scores A Correction Not A Bear Market A Correction Not A Bear Market

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

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

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

Highlights Gold prices will continue to be challenged by conflicting information flows regarding US monetary policy; higher inflationary impulses from commodity prices and supply-chain bottlenecks; global economic policy uncertainty, and risks to EM economic growth (Chart of the Week). Concern over the likely tapering of the Fed's asset-purchase program this year, rate hikes next year and fiscal-policy uncertainty will support rising interest-rate risk premia and a stronger USD. These will remain headwinds for gold. Going into the Northern Hemisphere's winter, risk premia in fossil-fuel prices are at or close to their zeniths, as is the Bloomberg commodity index. This will keep short-term inflation elevated. Heightened geopolitical tensions – particularly between Western democracies and China – will keep the USD well bid by risk-averse investors. The commodity-induced element of PCEPI inflation will be transitory. Uncertainty over US monetary policy and rising geopolitical tensions, however, will remain part and parcel of gold fundamentals indefinitely. The trailing stop on our long 1Q22 natural gas call spread – long $5.00/MMBtu call vs. short $5.50/MMBtu call – was elected, leaving us with a 20% gain. We will not be re-setting the spread at tonight's close, due to the difficulty in taking a price view in markets with extremely high weather-related uncertainty. Feature The quality of information informing the analysis of gold markets is highly uncertain at present. US monetary policy uncertainty and the future of Fed chairman Jerome Powell keep expectations twitchy when it comes issues like the tapering of the Fed's asset-purchase program. Our colleagues at BCA's US Bond Strategy expect the Fed will announce a taper in asset purchases by November 2021 which will end in June 2022.1 But the tapering really is not, in our estimation, as big a deal as inflation and inflation expectations, which will drive the Fed's rate-hiking timetable. Chart of the WeekUncertainty Weighs On Gold Uncertainty Weighs On Gold Uncertainty Weighs On Gold The first Fed rate hike expected by our bond desk likely will come at the end of next year. Our colleagues expect the Fed will want to check off three criteria before increasing interest rates (Table 1). The inflation targets – actual and expected – already have been checked off, leaving the labor market's recovery as the only outstanding issue on our internal checklist. By December 2022, once the maximum employment criterion has been met, the Fed will commence with rate hike.2 Subsequent rate hikes will depend on inflation expectations. Table 1A Checklist For Liftoff Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold Uncertain Inflation Expectations The higher inflation that checks off our bond desk's list resulted from COVID-19-impacted services and tight auto markets (Chart 2). We also find evidence commodities feed into inflation expectations and realized inflation, both of which are key variables for the Fed (Chart 3). Transitory effects – chiefly supply-chain bottlenecks and a global scramble for coal, gas and oil – have lifted realized inflation in 2H21, and have taken the Bloomberg commodity index to record levels (Chart 4). Nonetheless, given the fundamental backdrop for the key industrial commodities – chiefly oil, gas, coal and base metals – the inflationary impulse from commodity markets could persist indefinitely into the future, in our estimation. In order to incentivize the investment in base metals needed to literally build out the renewable energy infrastructure, the grids that support it and the electric vehicles that will supplant internal-combustion-engine technology, higher energy and metals prices will be required for years.3 This will be occurring as the production of traditional energy sources – i.e., fossil fuels – winds down due to lower investment over the next 10-20 years. This also will result in higher and more volatile oil and gas prices. Chart 2Inflation Meets Fed Targets Inflation Meets Fed Targets Inflation Meets Fed Targets Chart 3Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations All of these real-economy factors will feed into higher inflation over time, which will present the Fed with difficult choices regarding monetary policy and interest rates. Chart 4Record Commodity Index Levels Record Commodity Index Levels Record Commodity Index Levels USD Strength Suppresses Inflation And Gold Prices  It is worthwhile noting the current USD strength is suppressing inflation. However, it is not suppressing commodity prices entirely, as Chart 4 shows. The transitory weather-related price increases in energy commodities will pass, either when winter ends or if a less severe winter hits the Northern Hemisphere. We continue to expect a lower dollar, as the Fed's accommodative monetary policy remains in place. Even after the Fed tapers its asset-purchase program, policy will remain loose. The large fiscal packages that most likely will be approved by the US Congress will swell the US debt and budget deficits, which likely will weaken the USD over time. On a purchasing-power-parity basis (PPP) we also expect a weaker dollar (Chart 5). We also are expecting the availability of more efficacious vaccines in EM economies to boost economic activity, which will strengthen incomes and local currencies vis-à-vis the USD. Chart 5Weaker USD Expected On A PPP Basis Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold The risk to this USD view – which would support gold prices – remains the heightened geopolitical tensions between Western democracies and China, which will keep political uncertainty elevated and will keep the USD well bid by risk-averse investors. Persistent USD strength would restrain inflation, and weaken the case for owning gold. Investment Implications We remain bullish gold over the medium- and long-term, expecting higher inflation and inflation expectations to lift demand for this safe haven. However, persistent commodity-induced inflation could force the Fed to tighten monetary policy more than is currently expected to get out ahead of higher inflation and inflation expectations. This could lead to stagflation, wherein inflation runs high but growth stalls as interest rates move higher. Persistent geopolitical risk also will keep risk-averse investors well bid for the USD. Commodities Round-Up Energy: Bullish First-line US natural gas prices were down ~ 9% as we went to press, following reports Russia would make more gas available to European buyers. This report apparently was later contradicted by a Gazprom official, who said Russian inventories still were being filled ahead of winter.4 WTI crude oil prices came close to hitting a seven-year high early in the trading day Wednesday, then promptly retreated (Chart 6). The news flow is indicative of the extreme sensitivity of gas and oil buyers going into the coming winter. Base Metals: Bullish Earlier this week, the Peruvian government struck an deal with MMG Ltd, owner of the Las Bambas mine, and the local community around the site, which reportedly will involve hiring local residents to provide services to the mine, including helping transport minerals and maintaining key transit roads. The community had been protesting to seek more of the income from the mine, and created blockades en route to the site, which threatened ~ 2% of global copper supply. Peru's newly elected president, TK Castillo, rose to power on the promise to redistribute mining wealth to Peruvian citizens. This was his first negotiation with a mining company since his election in July. MMG’s major shareholder is China Minmetals Corp. The Leftist president will need to balance the interests of local stakeholders on the one hand, while ensuring the world’s second largest copper producing nation is still attractive to international miners. Precious Metals: Bullish In 2021, the World Platinum Investment Council expects the platinum to swing to a physical surplus of 190k oz, which reverses an earlier forecast for a deficit made in the Council's 1Q21 report (Chart 7). Demand is forecast to increase year-over-year, spurred by increases in automotive, industrial and jewelry demand. On the supply side, growth in South Africa's mined output growth will keep markets in a surplus for 2021. According to SFA Oxford, gross palladium demand and refined supply for 2021 are expected to be at 10.03mm oz, and 6.77mm, respectively. Palladium balances (ex-ETFs) are projected to remain in a physical deficit of 495k ounces for 2021. Chart 6 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 7 Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold   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 Damage Assessment, published by BCA Research's US Bond Strategy on September 28, 2021. 2     Please see 2022 Will Be All About Inflation, published by BCA Research's US Bond Strategy on September 14, 2021, which notes the concept of maximum employment is not a well-defined term. 3    Please see La Niña And The Energy Transition, which we published last week. 4    Please see Energy price surge sends shivers through markets as Europe looks to Russia published by reuters.com on September 6, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

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