Capex

Image We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Growth Will Continue To Be Above Trend Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Growth Will Be Boosted By The Wealth Effect... Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production ...And Capex To Increase Production ...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Covid Cases Not Leading to Hospitalizations And Deaths Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Fed Hikes Have Usually Caused Only A Short-Lived Selloff Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots The Futures Market Is In Line With The FOMC Dots The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Tapering Didn't Much Affect Stocks Either Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year Inflation Probably Will Decline This Year Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Year-On-Year Inflation Will Remain High Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? Risk Of A Price-Wage Spiral? Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Where Have All The Corrections Gone? Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow Stock Market Has Got Very Narrow Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chinese Data Looks Very Poor Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Is Credit Growth Now Bottoming? Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Slump In China Property Is Not Over Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up It Will Take A While For Commodity Prices To Pick Up It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? What Can Drive Returns In 2022? What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Margins Likely To Slip From Record High Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Europe Is More Sensitive To China Slowing... Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap ...And Not Particularly Cheap ...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese US Treasurys Are Attractive to Europeans And Japanese US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Long Rates Low Given Fed Signaling Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation Breakevens Already Pricing In A Lot Of Inflation Breakevens Already Pricing In A Lot Of Inflation Chart 24 In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds ...As Are Some EM Dollar Bonds ...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Dollar To Rise On More Hawkish Fed? Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Gold Is Vulnerable To Rising Real Rates Gold Is Vulnerable To Rising Real Rates Chart 27 Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation 

Dear Client, This week we present our annual Commodities & Energy Strategy outlook, which contains our key views on the principal markets we cover – energy, base metals and bulks, precious metals, and ags.  Over the coming decade, we expect industrial commodity prices to move higher in an increasingly volatile fashion, not unlike these markets' recent experience.  In the short term, commodity markets will remain exquisitely sensitive to the evolution of the COVID-19 pandemic.  The highly transmissible omicron variant of the coronavirus – now spreading at more than 4x the rate of the delta variant – appears to be less lethal than previous mutations, suggesting it could become the dominant variant globally.  We remain wary, however, particularly as China still is operating under a zero-tolerance COVID-19 policy, and has relied on less efficacious vaccines that appear to offer no protection against the omicron variant of the coronavirus.  This also is a risk for EM economies that rely on these vaccines.  However, the roll-out of mRNA vaccines globally via joint ventures will be gathering steam in 2H22, which is bullish for commodity demand. Longer term, the effort to decarbonize global energy markets is gaining traction, with the three largest economies in the world – the US, China and EU – embarked on a massive transition to renewables.  This will be a multi-decade undertaking that literally could transform the world.  We expect this to continue to unfold in an erratic and uncoordinated fashion, as states work out how to decarbonize the production, delivery and consumption of goods and services.  Markets critical to this transition, particularly base metals, face long odds developing the supply that will be necessary for this effort.  Conventional energy markets – oil, gas and coal – are in a forced wind-down imposed by courts, investors, governments, climate activists, public opinion and policymakers, which is reducing supply at a faster rate than demand.  This leaves markets exposed to volatile price bursts.  As is our custom, this will be the last CES report of the year.  This decade promises to be extraordinary for commodities, and we are hopeful we will continue to be of service in navigating the epic transition to a low-carbon future.  As you gather with friends and loved ones, we wish you all the best in this beautiful season, Robert Ryan Chief Commodity & Energy Strategist Highlights Macro: Bullish. Systematically important central banks will remain wary of moving too strongly too soon, in the wake of the COVID-19 omicron variant. US real rates will remain low and the USD will weaken, which will support commodities. Energy: Bullish. OPEC 2.0 and the price-taking cohort will maintain existing production policies, which will restrain oil supply. The omicron variant likely will dent demand, not tank it. Our 2022 Brent forecast is slightly weaker on omicron risk, averaging $78.50/bbl, with most of the demand hit in 1H22 made up in 2H22, while our 2023 forecast is $80/bbl. Base Metals: Bullish. Supply-demand balances will remain tight. Climate activism in courts and boardrooms; ESG-related costs, local and geopolitical uncertainty will continue to weigh on supply. COMEX copper will average $4.80/lb next year and $6.00/lb in 2023. Precious Metals: Bullish. Rising commodity prices will feed directly into inflation gauges favored by the Fed. Inflation and inflation expectations will remain elevated. Gold will push to $2,000/oz and silver to $30/oz in 2022. Ags/Softs: Neutral. Ag markets will remain balanced, with a bias to the upside from higher costs of fertilizer and transportation. Erratic weather remains an upside risk. Risk: Elevated. On the upside, a less lethal omicron variant that dominates other COVID-19 variants will rally markets. A more virulent mutant would hit demand harder and push prices lower. Hospitalizations/Cases and Deaths/Cases remain the critical ratios – trajectories need to remain flat to downward for growth (Chart of the Week). Recommendations: Our COMT ETF position was stopped out on 13 December 2021, which is when the ETF went ex-dividend. The ETF paid $5.4941/share for an 18.44% dividend (p.a.). Our stop-loss is being overridden, and we remain long the COMT ETF, in the expectation commodity markets will remain tight and backwardation will continue to drive returns. Feature COVID-19 continues to determine the trajectory of global growth – hence commodity demand – and how it will be distributed in the short run. Reports this week indicating the widely used Sinovac COVID-19 vaccine used in China and EM states is ineffective in neutralizing the omicron variant will renew the focus on an underappreciated risk: High vaccination rates in and of themselves are not useful indicators of successful public-health responses.1 More than anything, what appears to matter most is the vaccine that's been used to address the public-health threat posed by COVID-19. A booster of the Pfizer-BioNTech mRNA vaccine, e.g., appears to neutralize the omicron variant, and to convey a higher likelihood of avoiding serious illness and hospitalization.2 Chart 1 This will be important going forward, as the COVID-19 omicron variant appears to be transmitted at a rate that is 4.2x as contagious as the delta variant. This raises the odds that hospital beds will fill faster as the omicron mutant spreads.3 This could again lead to reduced availability of health care, and additional lockdowns to contain the spread of the omicron variant, which would again radiate through global supply chains. Oil Market Outlook Hinges On Omicron Response The risk exposed in these public-health developments is the global commodity recovery – particularly for crude oil and refined products like gasoline and jet fuel – could become more bifurcated this year, with economies using primarily mRNA technology continuing to open and recover. States without access to or distribution of these vaccines will have to rely more on social distancing and lockdowns to contain the spread of the virus. We would expect this to be a powerful inducement to accelerate local production and distribution of mRNA vaccines in Asia, Latin America and Europe. Successful implementation of this strategy would boost commodity demand, particularly for transportation fuels.4 Our prior regarding the omicron variant is it will dent demand but not tank oil demand. To account for the so-far-unknown effects of omicron, we are assuming 1H22 global crude and refined-product demand falls to 100.4mm b/d, versus our earlier estimate of 101.5mm b/d. Most of this demand is recovered in 2H22, when we expect oil consumption to average 101.8mm b/d versus our earlier expectation of 102.5mm b/d. On the supply side, OPEC 2.0 core producers – KSA, Russia, Iraq, UAE and Kuwait – will continue to implement the coalition's production-management strategy – i.e., keeping the level of supply just below demand. Meanwhile, the price-taking cohort led by the US shale-oil producers will continue to focus on profitability, not production for the sake of production. Accelerating production too rapidly at this point would undo much of the work and effort undertaken to establish oil and gas companies as attractive alternatives for investors. Our 2022 Brent forecast is weaker by $1.50/bbl vs last month's estimate, averaging $78.50/bbl. Our 2023 forecast is $1/bbl lower, with our average expectation at $80.00/bbl (Chart 2). Longer term, oil + gas capex remains weak (Chart 3). As we have stressed repeatedly, this is wicked bullish for prices in 2024 and beyond. Chart 2Brent Forecast Slightly Weaker In 2022 Brent Forecast Slightly Weaker In 2022 Brent Forecast Slightly Weaker In 2022 Chart 3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 2022 Key Views: Past As Prelude For Commodities 2022 Key Views: Past As Prelude For Commodities Weak Capex Keeps Base Metals Outlook Bullish Weak capex is a common theme in the industrial commodities – oil and base metals – which points to tight supply-demand balances for these markets going forward. This is as true for base metals as it is for oil (Chart 4). The principal drivers of the capex squeeze are similar in both markets: A desire to regain investors' favor after years of poor returns. This has managements focused on returning capital to shareholders either in the form of share buybacks or higher dividend payments. However, there are additional pressures adding to the cost structures of industrial commodities, particularly the seismic shifts in the political underpinnings of commodity-exporting countries, where left-of-center politicians are proving more attractive to the median voter in states with contestable elections. Once elected – e.g., in Peru, and, likely Chile after this weekend's elections – politicians push hard to secure a greater share of mining revenues for long-neglected poor and indigenous populations.5 Chart 4 The bellwether base metal market – copper – best highlights these factors, which, in our view, will keep base-metals capex tentative and restrained over the medium term. Miners are almost forced to exercise capex restraint until they get greater clarity on how newly elected governments will deliver on their avowed intent to secure a greater share of mining revenues for their constituents. This is particularly true in Chile and Peru – which together account for a combined 40% of global copper ore output – where poor and indigenous populations are engaging in more frequent civil disobedience.6 In addition to the contentious changing of the guard at the political level, ESG-related initiatives brought to the fore by climate activists elected to corporate boards and in court proceedings are adding new layers of cost to base-metals mining (and oil and gas exploration for that matter). This week, Reuters reported on separate court decisions in Australia and Chile that redress mistreatment of aboriginal peoples in key metals-exporting states.7 We believe political and ESG-related costs will raise miners' all-in sustaining costs, which will have to be covered by higher prices going forward. The additional costs that will be imposed on miners trying to meet the demand that will be driven by the global decarbonization and renewable-energy buildout now kicking into high gear will require prices to spur investment in new mine production, and to keep existing and brownfield production up and running.8 Copper prices will get an assist from a weaker USD, which will boost demand for the metal ex-US (Chart 5). We are expecting copper to push to $4.80/lb on average next year and $6.00/lb in 2023 on the COMEX, on the back of stronger supply fundamentals and a weaker USD. Chart 5A Weaker USD Will Boost Copper A Weaker USD Will Boost Copper. A Weaker USD Will Boost Copper. Gold Will Rally As Inflation, Uncertainty Remain Elevated Gold prices will move higher in 2022 – our target remains $2,000/oz – as investors seek cover from higher commodity prices, which will feed directly through to higher inflation (Chart 6).9 This has been apparent in the recent US PCEPI and core PCEPI – the Fed's preferred inflation gauge – and CPI data, and at the wholesale level in PPI data. Most of this results from tight supplies for commodities and strong demand for goods, which is driving the price increases. We expect this to continue into 2022, as pent-up consumer demand continues to drive goods purchases and supply-side tightness for most manufacturing inputs. Higher prices across commodity markets will keep inflation gauges elevated in 2022. In addition to the inflation-hedging demand we expect next year, investors also will turn to gold as a hedge against economic policy uncertainty: As inflation and policy uncertainty increase, gold prices move higher (Chart 7). Chart 6Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Higher Commodity Prices Will Pressure Inflation Higher Chart 7Investors Will Use Gold To Hedge Inflation, Uncertainty Investors Will Use Gold To Hedge Inflation, Uncertainty Investors Will Use Gold To Hedge Inflation, Uncertainty   Lastly, in line with our colleagues in BCA's Foreign Exchange Strategy service, we remain USD bears in 2022. As is the case with all commodities, gold will benefit from a weaker USD.10 Ags Remain Balanced In 2022 Global ag markets, by and large, will remain balanced over the current crop year (Chart 8), with a bias to the upside as input and transportation costs – chiefly fertilizers and grain vessels, respectively – remain high (Charts 9 and 10). Erratic weather, as always, remains an upside risk. Chart 8 Chart 9 Chart 10… And Fertilizer Costs Will Push Grains, Beans Higher Natgas Price Surge Pushes Fertilizer Prices Higher Natgas Price Surge Pushes Fertilizer Prices Higher While we remain neutral grains, the periodic price spikes resulting from higher freight rates and natural gas prices will support overall commodity exposures. Over the short term, the risk of higher prices is acute: Markets still are contending with the possibility of another colder-than-normal winter. This would push natgas prices – and, because it is 70% natgas, fertilizer costs – sharply higher next year. This will have to be recouped by higher food prices, particularly if shipping costs spike higher due to COVID-19-induced port closures. Surging food prices will keep inflation rates higher globally, making them more persistent (vs. transitory). Investment Implications Global supply-demand fundamentals continue to support our conviction commodity markets will remain tight in 2022. As such we remain long commodity index exposure – the S&P GSCI and COMT ETF – expecting market tightness to result in renewed backwardation. We also remain long the PICK expecting continued tightness in base metals. Risks to our views remain elevated – and occur in both directions. On the upside, commodities will rally if a less-lethal omicron variant becomes the dominant COVID-19 strain and does not overly tax hospital resources or drive death rates higher. It could actually convey a global benefit as the dominant strain, crowding out other mutations and pushing states to herd immunity. On the downside, it's still too early to tell how this new variant and other mutations will behave. Given the fragility of the current global recovery and reopening shown in the initial response to omicron, a more virulent mutant likely would hit aggregate demand hard, forcing yet another supply-side adjustment in commodities generally. Upside risks dominate in our assessment, but, as always, we remain cautious.   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 Sinovac shot offers inadequate shield from Omicron variant, says HK study published by straitstimes.com on December 15, 2021. The Sinovac vaccine is almost half as effective as mRNA-based vaccines, and is widely distributed in EM economies. We flagged this risk earlier in July in our report titled Assessing Risks To Our Commodity Views; it is available at ces.bcaresearch.com. 2     Please see Pfizer Booster Shots Are Effective Against Omicron Variant, Israeli Study Says published by wsj.com on December 12, 2021. 3    Please see Omicron four times more transmissible than Delta in Japan study published by straitstimes.com on December 9, 2021. 4    Please see Upside Price Risk Rises For Crude, which we published on September 16, 2021, for addition discussion of the global joint-ventures engaged in local production of mRNA vaccines. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021 and Chile: Prepare For A Boric Win, published by BCA's Emerging Markets Strategy service on December 15, 2021. The latter report discusses the growing odds of a victory for the left-of-center candidate in Chile's election this weekend. 6    Please see, e.g., Peru's poor Andean hamlets, backed by state, unleash anger at mines, published by reuters.com on December 14, 2021. 7     Please see Australian mining state passes Aboriginal heritage protection law, and Chile's Supreme Court orders new evaluation of Norte Abierto mining project published by reuters.com on December 15 and 14, 2021, respectively. 8    Incremental investment needed to meet 2050 net-zero climate goals will come to almost $2 trillion per year, half of which will go into renewable power generation, industrial processes, and transportation, according to estimates by Goldman Sachs, published on December 13, 2021. 9    Please see More Commodity-Led Inflation On The Way, which we published on December 9, 2021. It is worthwhile reiterating Granger-causality between realized and expected inflation gauges (US PCEPI, core PCEPI, CPI, along with 5-year/5-year CPI swap rates) and commodity price indices (the S&P GSCI and Bloomberg Commodity Index) is very strong. 10   Please see 2022 Key Views: Tug Of War, published by BCA's Foreign Exchange Strategy service on December 10, 2021.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Highlights Tight commodity markets, rising incomes, and constrained logistics networks will continue to push inflation gauges higher, so long as coronavirus mutations don't cause another global economic shutdown. Commodity price pressures – exacerbated by weak capex on the supply side – will feed directly into realized and expected inflation gauges going forward, just as they have this year (Chart of the Week).  In the short run, tight natural gas markets will raise fertilizer prices, which will keep food prices elevated next year. Inflation in goods prices will persist as tight energy and base-metals markets keep input and transportation costs elevated. Political uncertainty in important energy- and metals-exporting states, and ESG-related costs will contribute to upside price pressures.  The cost of building the infrastructure required to decarbonize the global economy – an effort now kicking into high gear – is heavily dependent on the availability of base metals and fossil fuels, which means the cost of this energy transition likely will rise. Against this backdrop, central banks’ room to maneuver will shrink – tightening policy to fight inflation risks will drive up hurdle rates and make supply-side investment more costly. We remain long gold as a hedge against inflation and policy uncertainty, and our commodity-index exposures (S&P GSCI and the COMT ETF). Feature The Fed's preferred inflation gauge, the core Personal Consumption Expenditures Price Index, is up 4.12% y/y; the overall index is up 5.05%. In the euro zone, inflation soared to record highs in November, reaching 4.9% y/y. Most of the surge in these inflation gauges is due to higher commodity prices, which are caused by tight markets globally: In many markets, particularly energy and metals, the level of demand exceeds that of supply, which is forcing inventories lower and prices higher. Supply has been slow catching up with demand post-pandemic. There is a direct feed through from commodity markets to price inflation, something markets will be reminded of repeatedly in coming years as the supply-side of critically important commodities – energy, metals and food – are stressed to keep up with demand (Chart 2).1 Chart of the WeekRealized, Expected Inflation Will Continue To Rise Realized, Expected Inflation Will Continue To Rise Realized, Expected Inflation Will Continue To Rise Chart 2Feedthrough From Commodities To Expected Inflation Is Strong Feedthrough From Commodities To Expected Inflation Is Strong Feedthrough From Commodities To Expected Inflation Is Strong The scope for central banks to act to contain inflation in such circumstances is constrained: Tightening policy to the point where the cost of capital becomes prohibitive will exacerbate supply-side constraints in energy and metals markets. The risk here is acute, given that a decade of monetary policy operating close to the zero bound has failed to encourage long-term investment on the supply side in oil, gas, and metals. The dearth of capex in energy (Chart 3) and metals (Chart 4) threatens to keep supplies constrained for years. Chart 3 Chart 4 Short-Run Pressure On Food Prices In earlier research, we delved into the sharp rise in food prices, and the underlying causes (Chart 5). Some of these are transitory – e.g., the tight shipping market for grains brought about by clogged logistics markets and delays in sailing, which has lifted rates sharply over the course of this year (Chart 6). Chart 5 Chart 6 Other factors – high natural-gas prices, which will drive fertilizer prices higher next year – will dog markets at least until 2H22, when natural gas inventories in Europe will be on their way to being rebuilt, following a difficult injection season this year (Chart 7). The scramble to find gas in Europe and Asia as distributors prepare for a La Niña winter will take time to recover from next year.2 Chart 7High EU Gas Prices Will Keep Fertilizer Prices Elevated High EU Gas Prices Will Keep Fertilizer Prices Elevated High EU Gas Prices Will Keep Fertilizer Prices Elevated Energy, Metals PricesDrive Inflation Expectations The really big inflationary push over the next five to 10 years will come from energy and metals markets, where capex has languished for years, as can be seen in Charts 3 and 4. These markets have been and remain in persistent physical deficits, which will not be easy to reverse without higher prices over a sustained period (Charts 8 and 9). Chart 8Oil Markets Will Remain In Deficit... Oil Markets Will Remain In Deficit... Oil Markets Will Remain In Deficit... Chart 9...As Will Metals Bellwether, Copper ...As Will Metals Bellwether, Copper ...As Will Metals Bellwether, Copper These markets will exert a strong influence on inflation and inflation expectations for as long as capex remains weak and supply is constrained. As can be gleaned from the model shown in Chart 10, the London Metal Exchange Index (LMEX) and 3-year-forward WTI are good explanatory variables for US 5-year/5-year CPI swap rates, the trading market in which inflation expectations are hedged. Until markets see sustainable investment in base metals and hydrocarbons over the course of the global energy transition now underway, forward-looking inflation markets will continue to price to tighter supply expectations. Chart 10 Gold's Role As A Hedge Against Inflation, Uncertainty In our modeling we often describe gold as a currency, which, similar to other currencies, is highly sensitive to US monetary variables, EM and DM income (as measured by nominal GDP), economic policy uncertainty, and core inflation (Chart 11). These variables are what we could call the "usual suspects" that typically are rounded up to explain inflation, in addition to commodities prices.3 In Chart 12, we zero in on one of the inflation gauges discussed above, which is extremely sensitive to commodity prices, and policy uncertainty. Here we show gold as a function of US Economic Policy uncertainty and US PCEPI to make the point that gold can hedge not only the inflation driving these indices, but the economic uncertainty that likely will attend the transition to a low-carbon future, which we expect will remain elevated during this transition. Chart 11Gold Prices Sensitive To Usual Suspects Gold Prices Sensitive To Usual Suspects Gold Prices Sensitive To Usual Suspects Chart 12...Particualrly Inflation And Uncertainty ...Particualrly Inflation And Uncertainty ...Particualrly Inflation And Uncertainty Investment Implications Much of the surge showing up in inflation gauges in the US and EU is being driven by strong commodity prices. These prices are being powered higher by strong income growth, which leads to strong demand; tight supplies, and inventories. As we have noted, the level of commodity demand exceeds that of supply, which is forcing inventories lower and prices higher in oil and metals markets. Going forward, these fundamentals will be slow to change, which argues in favor of our long gold position and our long commodity index positions (S&P GSCI and the COMT ETF). We reiterate the COVID-19 risk factor mentioned at the beginning of this report: Global aggregate demand still is fragile. The risk of another coronavirus shock remains high. In particular, China maintains its zero-tolerance COVID-19 policy. This means commodity markets have to remain alert to how policymakers respond if the highly contagious Omicron variant is detected and authorities once again shut down ports and travel. The risk of disrupted supply chains and hits to supply-demand balances next year remains acute.4     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 Crude oil prices rebounded following its Omicron-induced drop last week. Relative to last Wednesday - when brent closed at its lowest following news of the new variant - prices were up 9.54% as of Tuesday’s close (Chart 13). Saudi Arabia’s decision to increase the official selling price of oil to customers in Asia and the US is testimony to its belief global demand will remain strong, despite the emergence of the highly transmissible new COVID-19 variant. Base Metals: Bullish Ever since the Omicron variant of COVID-19 was disclosed, prices of base-metals bellwether copper have become more volatile. This mostly reflects uncertainty surrounding macroeconomic conditions, as characteristics of the latest variant of the coronavirus are not well-known. COVID-19 lockdowns due to the Omicron variant could potentially delay tightening stimulus measures, which will be positive for industrial metals. However, lockdowns will also reduce industrial activity and demand for the red metal, acting as a sea anchor on copper's price. At the start of this week, looser monetary policy and rising copper imports in China supported the red metal, however these gains were capped by fears regarding the Omicron variant and a strong USD. Despite the volatility in copper prices following Fed Chair Jay Powell’s remarks last week on the pace of the asset purchases, we continue to expect tight fundamentals will outweigh the bearish effects of a stronger USD, and the weaker global financial conditions which come with it (Chart 14). Precious Metals: Bullish The World Platinum Investment Council (WPIC) reported a large third quarter refined platinum surplus of 592k oz, up nearly 430k oz from the second quarter. The jump in the third quarter surplus means the organization expects a full year 2021 surplus of 792k oz, compared to the 190k oz it had forecast in its second quarter report. Increased refined supply due to accelerated processing of 2020 semi-finished platinum stock coupled with lower demand by automakers and outflows from ETFs and stocks held by exchanges propelled the global platinum market into this relatively large surplus. In 2022 South African mined supply is expected to remain stable, while demand is expected to pick up as the economic recovery continues, resulting in a surplus of 637k oz for the full year. These forecasts do not account for the latest Omicron variant which was first reported in South Africa. Lockdowns due to the virus could lead to mine closures in the world’s largest platinum producer and reduce platinum demand from automakers. Chart 13 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 14 Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions   Footnotes 1     We find Granger-causality between realized and expected inflation gauges (US PCEPI and core PCEPI; US CPI, and US 5-year/5-year CPI swap rates) and commodity price indices (the S&P GSCI and Bloomberg Commodity Index) is very strong.  This indicates the commodity-price indices are good explanatory and predictive variables for realized inflation gauges and for inflation expectations. 2     Please see our November 11 report entitled Risk Of Persistent Food-Price Inflation for additional detail. 3    Please see Conflicting Signals Challenge Gold, which we published on October 7, for example. 4    Please see 2022 Key Views: A Challenging Balancing Act published by BCA Research's China Investment Strategy on December 8, 2021.   Investment Views and Themes Strategic Recommendations

Highlights Indian stocks need more time to digest and consolidate the significant gains from earlier this year. However, the country’s medium and long-term growth outlook remains positive. Indian firms’ profit margins will likely settle at a higher level than usual. That will also put a floor on its equity multiples. With an imminent topline recovery, the main driver of Indian stocks next year will be profits, in contrast with multiple expansions during the last year and a half. India is beginning a cyclical expansion with a cheap rupee. Stay neutral Indian stocks in an EM equity basket for now. Investors should overweight India in an EM domestic bond portfolio. Feature Chart 1Indian Stocks Are Overbought Indian Stocks Are Overbought Indian Stocks Are Overbought We tactically downgraded Indian stocks from overweight to neutral in EM and emerging Asian equity portfolios in early October this year. This call has worked out well so far as India’s absolute and relative share prices seem to have peaked. The primary reason for our tactical “neutral” call on Indian equities was this market’s vertical rise earlier this year, both in absolute and relative terms. Similar spikes – in terms of magnitude and duration back in 2007 and in 2014 – were followed by a period of underperformance (Chart 1). Yet, we recommended downgrading to only a neutral allocation. The reason is that the country’s cyclical outlook remains constructive, and the profit expansion cycle has further to run. That forbade us from turning too bearish on this bourse. A neutral stance on India also makes sense for the next several months as this bourse digests and consolidates its previous gains. In this report, we detail the various nuances of our analysis. Meanwhile, the Indian currency is cheap versus the greenback and will likely be one of the best performing currencies in the EM world over the next year. A positive currency outlook also makes Indian government bonds attractive for foreign investors, as Indian bonds also offer a high yield amid a benign domestic inflation backdrop. Dedicated EM domestic bond portfolios should stay overweight India. Equity Multiple Compression Ahead? Chart 2India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating An upshot to the steep equity rally earlier this year has been India’s stretched valuations. That made many investors question the sustainability of the outperformance. A pertinent question, therefore, is how overvalued have Indian stocks become? And how much multiple compression can investors expect in this bourse? Before we answer this question, it’s useful to understand what drove the cyclical re-rating of Indian markets in the first place. The solid black line in Chart 2 shows the gross profit margins of all Indian listed non-financial firms. They have risen substantially since spring 2020 to reach decade-high levels. Margin expansions of this magnitude are indicative of material efficiency gains; and are usually rewarded with an equity re-rating. This is indeed what happened since spring 2020: stock multiples rose following the expanding margins. The same can be said if we only consider the major non-financial corporations’ EBITDA margins (Chart 2, bottom panel). If one looks at the cyclically adjusted P/E ratio (CAPE) instead, we see a very similar thing: the CAPE ratio has also risen in line with rising profit margins (Chart 3). Chart 3Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Charts 2 and 3 show that the positive correlations between profit margins and stock multiples held steady over past several cycles. Hence, it will be reasonable to expect that should Indian firms hold on to wide margins, they will not suffer a significant de-rating going forward. Can Margins Stay Wide? Chart 4Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Before we delve into the question of whether margins can stay wide, we need to understand what caused such a margin expansion in the first place. That cause is cost cutting: wage bills have gone down as businesses slashed employees. Data from Oxford economics show that there had been 9% fewer workers in India as of September 2021 compared to March 2020, just before the pandemic. Interest expense has also gone down – both relative to sales and profits (Chart 4) – as interest rates were cut aggressively. In our view, the latest rollover in profit margins will likely be temporary and limited. It is probably due to hiring back of some employees. Beyond a near-term limited drop in margins, the more relevant question to ask is, can Indian corporations maintain high margins? Our bias is that, to a large extent, they can. The main reason is that firms’ costs are slated to stay under control: Chart 5Indian Companies Do Not Face Any Wage Pressures Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Wage expectations are low. Going forward, as millions of new job seekers and workers temporarily discouraged by the pandemic enter the job market, wages have little chance of much of an increase. The top panel of Chart 5 shows salary expectations from an industrial survey by RBI. Both the assessment for the current quarter and expectations for the next quarter have been a net negative for a while. Rural wages are also similarly timid (Chart 5, bottom panel). Notably, companies’ hiring back of employees is slow. It seems they prefer to substitute labor by capital by investing in new machines and equipment. This will boost productivity and cap wages. Overall, high productivity growth will keep companies’ profit margins wide and excess labor will suppress wages. Higher margins and low inflation are bullish for the stock market. Critically, headline inflation is within the central bank target bands, and our model shows that it will likely remain as such (Chart 6, top panel). Core inflation is also likely to stay flattish (Chart 6, bottom panel). This means the odds are that the central bank will not raise rates anytime soon. Flattish inflation and policy rates mean firms’ borrowing costs, in both nominal and real terms, are slated to stay approximately as low as they are now. Low real borrowing costs are usually a tailwind for stocks (Chart 7). Chart 6 Chart 7Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks     All put together, Indian companies will likely see their costs largely under control. That, in turn, should keep profit margins wider than usual. Wide profit margins should limit multiple compression. Can The Topline Rise Further? Wider margins will boost total profits if and once the topline (revenues) recovers. So, the next question is, how much topline recovery is in the cards? Chart 8Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode There are already signs that sales will likely accelerate in the months to come: PMI indexes for both the manufacturing and services sectors have recovered strongly since the Delta variant-induced lockdowns in spring. They are now hovering around a very high level of close to 60. This indicates that the economy is in a rapid expansion mode (Chart 8). The Industrial Outlook survey (conducted by the RBI) shows that the order books for the September quarter was already at a decade-high level. The expectation for the next few quarters is even more elevated – indicating strong momentum (Chart 9, top panel). In other surveys, such as the PMI and Business Expectation survey (from Dun & Bradstreet), we see similar strong order books (Chart 9, bottom panel). While orders are strong, inventory of finished goods is low. Not surprisingly, businesses are expecting very high-capacity utilization in the next few quarters (Chart 10, top two panels). Chart 9Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Chart 10Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead They are expecting to hire more people. Companies also believe consumer demand will revive which will enable wider profit margins. In sum, firms are optimistic about accelerating economic activity (Chart 10, bottom two panels). Chart 11A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity This, in turn, is encouraging them to make capital investments. Finally, the commercial banks’ credit impulse has also turned positive. Rising bank credit impulses usually signal stronger industrial production (Chart 11). To summarize, chances are that firms’ top lines are set to rise materially. Coupled with high margins, this will translate into strong profit acceleration in the next several quarters. Put differently, over the past year and a half, Indian firms witnessed rising margins. Going forward, they will likely see rising profits. Higher profits, in turn, will propel Indian share prices cyclically beyond any short-term consolidation. A Sustainable Expansion? In a notable departure from most developed countries, India’s recovery from the pandemic-induced recession has been more capex-led, rather than consumption-led (Chart 12). One reason for that is the Indian government did not supplement the lost household incomes during the lockdowns nearly as much as developed countries did. That, in turn, kept household demand low. And it also contributed to keeping inflation in check – even though India’s supply side was also paralyzed due to strict lockdown measures. On the other hand, firms’ profits soared owing to rigorous cost-cutting. Higher profits in turn have encouraged firms to expand their production capacity. Companies are ramping up capital spending as they expect sales to accelerate in the future (Chart 13). Chart 12A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion Chart 13Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Notably, the combination of curtailed household demand and robust capital expenditure has set India’s inflation dynamics apart from many other countries in Latin America and EMEA. While India’s inflation remains largely contained, countries in those regions are witnessing accelerating inflation.  Also, over a cyclical horizon, a capex-led expansion is very crucial for India as this will determine the duration and magnitude of the cycle. Strong investment expenditures do not only boost firms’ competitiveness and profitability, but they also help keep inflationary pressures at bay. Lower inflation for a longer period means the central bank need not raise rates as soon and/or as much as otherwise would be the case. That in turn allows the economic and profit expansion to continue for longer. An extended period of expansion is also positive for multiples as investors extrapolate profit growth over many years ahead. India’s current dynamics are a case in point. Given the country is facing no imminent interest rate hikes, stock multiples can stay higher for longer. This is because multiple de-rating commences only after meaningful rate hikes have already been accorded (Chart 14). Since that is quite far off, valuations are not facing any immediate and considerable headwinds. Finally, India is beginning the new cycle with a rather inexpensive currency. Chart 15 shows that the rupee is currently cheaper by about 10% than what would be its “fair value” vis-à-vis the US dollar. The fair value has been derived from a regression analysis of the exchange rate on the relative manufacturing producer prices of India and the US. Chart 14It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples Chart 15India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency   Investment Conclusions Equities: Given the vertical rise earlier this year, Indian stocks would likely need a few more months to digest previous gains and consolidate. Hence, even though the country’s cyclical outlook remains constructive, we recommend that dedicated EM and Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines and wait for a better entry point. Currency and Bonds: The rupee is cheap and could be one of the best performers within the EM world over a cyclical horizon. Indian government bonds also offer a good value with a rather high yield (6.4% for 10-year securities) amid a benign inflation outlook. A positive rupee outlook also makes Indian bonds more appealing for foreign investors. Investors should stay overweight India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Chart 4 Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. Chart 5 Chart 6 The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 13 Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. Chart 16 The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 17 Chart 18US Capex Should Pick Up US Capex Should Pick Up US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 21 Chart 22Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 24 Chart 25Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Dear Client, We had an error in our oil balances/forecasts report from 18 November 2021 resulting from a double counting of select US onshore production figures.  This has been corrected below. Highlights Higher oil production will restrain price increases in the short term, and give the impression the burst in inflation is transitory. Re-opening of airline travel and releasing of pent-up demand will absorb much of the higher output by year-end 2022. We are doubtful a US SPR release is forthcoming, as its impact would be trivial. Likewise, we do not expect the US to limit or ban exports of crude oil again, as it would unbalance markets. We are maintaining our Brent forecasts for 2022 and 2023 at $80 and $81/bbl. We again include a caveat, noting upside price risk is increasing going forward, due to inadequate capex (Chart of the Week). Stronger inflation prints going into 1Q22 will test the conviction underpinning central bankers' view that the current bout of price increases is transitory. If inflation appears to be more persistent going into 2H22, the Fed and other systemically important central banks likely will signal earlier-than-expected policy-rate hikes. This would be negative for commodities, as it would raise debt-service costs and investment hurdle rates, and reduce consumption. Higher oil prices and tighter monetary policy will temper demand. If capex is not forthcoming, however, prices will have to rise sharply to destroy demand. Feature It hardly deserves mention that the US has been hectoring the leadership of OPEC 2.0 to increase oil production, in order to reduce the cost of gasoline and home-heating fuels going into the winter … And, there's a mid-term election next year. The Biden administration also has been threatening – if that is the proper term – to release barrels from the US Strategic Petroleum Reserve (SPR), and reportedly asked China to consider a similar release.1 The leadership of OPEC 2.0, on the other hand, is flagging the risk to stronger oil prices from higher production next year. Much to the chagrin of the Biden administration, the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia will not be increasing output by more than the 400k b/d it agreed to earlier this year. OPEC 2.0 will keep this up until June or July 2022, when most of its output sidelined by the COVID-19 pandemic will have been returned to the market. We expect the core Gulf-state producers – mostly KSA – will want to maintain ~ 3mm b/d of spare capacity thereafter. Chart of the WeekStable Oil-Price Trajectory Stable Oil-Price Trajectory Stable Oil-Price Trajectory Chart 2OPEC 2.0 Production Continues To Lift OPEC 2.0 Production Continues To Lift OPEC 2.0 Production Continues To Lift Higher Oil Output Expected Overall OPEC 2.0 production is expected to total 52.3mm b/d next year and 53.1mm b/d in 2023 (Chart 2). Most of the increase in the coalition's production will be accounted for by its core producers – KSA, Russia, Iraq, the UAE and Kuwait (Table 1). The "Other Guys" – i.e., those producers in OPEC 2.0 that can only maintain existing output levels or are managing continual declines in output – will account for a decreasing share of the coalition's production (Chart 3).2 Chart 3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 High Oil Prices, Low Capex, Inflation … Oh, My. High Oil Prices, Low Capex, Inflation … Oh, My. Including drilled-but-uncompleted wells (DUCs), we expect an additional 600k b/d from US shale-oil producers next year, which would take their output up to 8.39mm b/d, and another 350k b/d increase in their output in 2023. Output in the Lower 48 (L48) states of the US overall is expected to increase to 9.65mm b/d next year and 9.93mm b/d in 2023 (Chart 4). The increase in L48 output will continue to be led by higher shale-oil production, notably from the prolific Permian Basin play (Chart 5). US Gulf of Mexico and Alaska production tops up our total average output forecasts in the States to 11.89mm b/d next year and 12.20mm b/d in 2023. Chart 4US L48 Production Continues To Grow US L48 Production Continues To Grow US L48 Production Continues To Grow Chart 5 Demand Continues To Expand On the demand side, we continue to expect 2021 consumption growth of ~ 5.0mm b/d this year. Our growth expectation for 2022 and 2023 remains close to ~ 4.6mm b/d and 1.3mm b/d, respectively. We also expect demand to cross back over 100mm b/d in the current quarter, as can be seen in Table 1. As has been our wont during the recovery from the pandemic, we expect DM demand to level off next year after a stout recovery, and for EM demand to pick up the baton and lead global oil-consumption growth in the next two years (Chart 6). We remain bullish re the rollout of COVID-19 vaccines using mRNA technology globally, which will allow EM economies to step up growth. Re-opening of DM and EM economies will continue, pushing refined-product demand above 2019 levels next year, including jet-fuel toward the end of 2H22. Chart 6EM Oil Demand Growth Will Take The Lead EM Oil Demand Growth Will Take The Lead EM Oil Demand Growth Will Take The Lead Oil Market Remains Balanced Our supply-demand balances are largely unchanged from last month. This keeps global crude-oil markets in a physical deficit for most of next year. We expect OPEC 2.0's core producers will maintain their production-management strategy – i.e., keeping the level of supply below the level of demand. Producers in the price-taking cohort outside the coalition – chiefly the US, Canada and Brazil – will lift production subject to capital-market constraints on producing oil profitably (Chart 7). This supply-demand dynamic keeps inventories drawing through this year, then leveling off in 2022 and rebounding slowly in 2023 (Chart 8). Chart 7Global Crude Markets Mostly Balanced Global Crude Markets Mostly Balanced Global Crude Markets Mostly Balanced Chart 8Crude Inventories Continue To Draw Crude Inventories Continue To Draw Crude Inventories Continue To Draw   Global crude-oil inventories could come under pressure during the 2021-22 winter, if natural-gas markets remain supply-constrained. This week, the Russian state-owned supplier and operator of Nord Stream 2 (NS2) pipeline delivering Russian gas to Germany was told it must comply with German law before its gas will be allowed to flow. It is unlikely this will be done this year.3 This could keep demand for oil higher at the margin, as we noted earlier.4 Oil's Known Unknowns: Capex, Inflation The big unknowns – and risks – to our view are when and how much capex is going to be deployed in the oil and gas exploration-and-production space, and what we can expect from the Fed and other systematically important central banks if inflation looks to be persistent. OPEC 2.0 leaders and officials from the price-taking cohort agree that the dearth of capex for the industry threatens to destabilize oil and gas markets in the near future. Among the 90 international oil and gas producers tracked quarterly by the US EIA capex has collapsed (Chart 9). The industry appears to have made shareholder and investor interests their priority, so as to be competitive in the pursuit of capital that all firms engage in. This also is true for state-owned entities, which also compete for capital and access to technology. Chart 9 These firms and producers will continue to work to produce oil and gas profitably. Still, they likely will continue to find an unreceptive audience to invest in these energy sources; Governments and policymakers are actively discouraging investment in fossil fuels. This risks setting in motion a process in which supply erodes much faster than demand – similar to what is happening in coal markets presently – and prices for fossil fuels rocket higher. This is not a strategy, particularly as it disregards the fact there is insufficient renewables capacity and storage to cover the energy from hydrocarbons that is being lost because of the lack of a transition policy at any level. Recent strong inflation prints are a small-scale example of how this process could play out over the next decade or longer. When China eliminated Australian coal imports earlier this year in favor of Indonesian supplies, and forced its coal mines to shut as part of its dual-circulation policy to become more self-reliant, the resulting shortages set off chain reactions in global natural gas markets. European gas prices shot higher, which, along with higher Asian and American natgas prices, sent food prices soaring on the back of higher fertilizer prices.5 Shipping bottlenecks and container shortages worldwide exacerbated these problems. CBs' Inflation View Challenged Going into 2022, central bankers' view that the current bout of price increases is transitory is going to be put to the test. If inflation appears to be more persistent going into 2H22 – after hoped-for one-offs in coal, gas, oil and food markets are worked out – the Fed and other systemically important central banks likely would start signaling earlier-than-expected policy-rate hikes. This would be negative for commodities generally, as it would raise debt-service costs and investment hurdle rates, and reduce consumption. Higher oil prices and tighter monetary policy will temper demand. These inflationary pressures can be addressed, but this will require a serious re-thinking of the strategy the world needs to pursue if it is to pull off a successful energy transition. Such a strategy will have to give greater consideration to the role of fossil fuels in this transition. If capex is not forthcoming, however, oil prices will have to rise to destroy demand. This will feed into inflation, and ultimately could result in stagflation, as economic growth grinds lower. Investment Implications The level of uncertainty surrounding oil and gas prices remains elevated, given the background condition of 90% odds we see a La Niña in the Northern Hemisphere's winter (Nov21 – Mar22), and ~ 50% chance it persists into the Spring (March-May22). This could leave markets with colder-than-normal temperatures past the end of winter, as it did last year. Given this uncertainty, we remain long the S&P GSCI and the COMT ETF, to keep our exposure to higher prices and a return to higher backwardation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish Natural-gas price volatility in Europe and the EU exploded higher once again, following reports the German government would not certify Nord Stream 2 (NS2) unless and until it complies with German law (Chart 10). The European Commission also is setting conditions for its approval. Lastly, outgoing Chancellor Angela Merkel said further sanctions against Russia were possible if the pipeline was used against Ukrainian interests.6 The EU's TTF natural gas benchmark is up 24% this week alone, on the back of this news, while the UK's benchmark Balancing Point index is up 7%. These higher costs will feed into food costs, given the importance of natural gas to fertilizer markets, accounting for ~ 70% of fertilizer costs.7 Given the higher likelihood of another La Niña in the Northern Hemisphere (90% odds from the US Climate Prediction Center), we expect continued volatility in gas prices. Base Metals: Bullish Steel demand in China has been contracting after the government began tightening the supply of credit to the property sector following the Evergrande debt crisis. Construction makes up approximately one-fourth of total Chinese steel demand. At the same time, supply has been falling as, in addition to government regulation to curb carbon emissions, steel mills have voluntarily cut output due to decreasing margins on the back of soft demand. The fact that Chinese steel prices have been falling since their highs in May this year indicates that demand is dropping faster than supply (Chart 11). Reduced Chinese steel demand is feeding through to demand for iron ore – the main steel input in China – while disruptions in the top two iron ore exporters, Australia and Brazil are easing, increasing the possibility of an oversupplied market. Precious Metals: Bullish Gold ended last Thursday above $1,860/oz for the first time since mid-June after the October CPI data release showed that the US had its biggest inflation surge in nearly 30 years. As long as the Federal Reserve does not turn more hawkish, consecutive months of high CPI prints will mean low real rates well into 2022, which will reduce the opportunity cost of holding gold. The high US twin deficits – which as of Q3 2021 was 17.44% of GDP – support the long-term dollar bearish view our colleagues at BCA's Foreign Exchange Strategy hold. A weak dollar over the next 12-18 months will increase the inflation-hedge appeal of the yellow metal relative to the greenback. Chart 10 Chart 11 GENERIC 1ST MONTH STEEL REBAR FUTURES PRICE LEVEL GOING DOWN GENERIC 1ST MONTH STEEL REBAR FUTURES PRICE LEVEL GOING DOWN   Footnotes 1     We note in passing the Biden administration has been mostly successful in getting massive fiscal and monetary stimulus deployed into the US economy, which has increased household savings and potential spending power dramatically, as our colleagues in BCA's US Investment Strategy noted in their 1 November 2021 report Half-Empty Or Half-Full?: "Massive fiscal transfers and an unprecedented increase in household wealth will support consumption and keep the economy from stagnating." We cannot view higher gasoline prices in the wake of this stimulus and growth as an economic emergency of the sort the SPR is designed to address. Nor can we view the pick-up in mobility – particularly in air travel expected shortly with the re-opening of routes closed due to the pandemic – as a supply-side emergency. 2     It's worthwhile mentioning here that OPEC 2.0 has been returning less than the 400k b/d every month it agreed due to shortfalls in production outside the core group broken out in Table 1. Reduced capex and maintenance is responsible for this. Higher oil prices might allow this group within the coalition to attract additional capex, but, given the uncertain long-term support for such exploration-production-maintenance investment, this will remain a long-term challenge to these producers. Lastly, we continue to expect Iran to return to markets as a bona fide exporter; we expect its production to return to 3.70-3.85mm b/d by 2H22. 3    Please see Nord Stream 2: Germany halts approval of Russian gas link published on November 16, 2021. 4    Please see last month's oil balances and price-forecast report Short-Term Oil-Price Risk Moves To The Downside, published 21 October 2021. 5    Please see our October 14, 2021 report entitled Inflation Surges, Slows, Then Grinds Higher, and last week's report entitled Risk Of Persistent Food-Price Inflation for additional discussion. 6    Please see fn 3 above. 7     Please see fn 5 above.   Investment Views and Themes Strategic Recommendations

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Revolving Credit On The Rise Again Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 8 Chart 9The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   Chart 10 The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 11 Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. Chart 14 In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas Chart 16 In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Image The markets were deluged by a lot of information in late October. Several central banks made surprise moves towards tightening (the Bank of Canada, for example, ended asset purchases, and the Reserve Bank of Australia effectively abandoned its yield-curve control). Inflation continued to surprise on the upside (headline CPI in the US is now 5.4% year-on-year). But, at the same time, there were signs of faltering growth with, for example, US real GDP growth in Q3 coming in at only 2.0% quarter-on-quarter annualized, compared to 6.7% in Q2. This caused a flattening of the yield curve in many countries, as markets priced in faster monetary tightening but lower long-term growth (Chart 1). Nonetheless, equities shrugged off the barrage of news, with the S&P500 ending the month at a new high. All this highlights what we discussed in our latest Quarterly: That the second year of a bull market is often tricky, resulting in lower (but still positive) returns from equities and higher volatility. For risk assets to continue to outperform, our view of a Goldilocks environment needs to be “just right”: The economy must not be too hot or too cold. We think it will be – and so stay overweight equities versus bonds. But investors should be aware of the risks on either side. How too hot? Inflation is broadening out (at least in the US, UK, Australia and Canada, though not in the euro zone and Japan) and is no longer limited to items which saw unusually strong demand during the pandemic but where supply is constrained (Chart 2). Chart 1What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? Chart 2Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US There is a risk that this turns into a wage-price spiral as employees, amid a tight labor market, push for higher wages to offset rising prices. We find that wages tend to follow prices with a lag of 6-12 months (Chart 3). The Atlanta Fed Wage Tracker (good for gauging underlying wage pressures since it looks only at employees who have been in a job for 12 months or more) is already at 3.5% and looks set to rise further. On the back of these inflationary moves, the market has significantly pulled forward the date of central bank tightening. Futures now imply that the Fed will raise rates in both July and December next year (Chart 4) and that other major developed central banks will also raise multiple times over the next 14 months (Table 1). Breakeven inflation rates have also risen substantially (Chart 5). Chart 3Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Chart 4Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon?   Table 1Futures Implied Path Of Rate Hikes Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks Chart 5Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation     We think these moves are a little excessive. There are several reasons why inflation might cool next year. Companies are rushing to increase capacity to unblock supply bottlenecks. For example, semiconductor production has already begun to increase, bringing down DRAM prices over the past few months (Chart 6). Another big contributor to broad-based inflation has been a 126% increase in container shipping costs since the start of the year (Chart 7). But currently the number of container ships on order is at a 10-year high; these new ships will be delivered over the next two years. Such deflationary forces should pull down core inflation next year (though we stick to our longstanding view that for multiple structural reasons – demographics, the end of globalization, central bank dovishness, the transition away from fossil fuels – inflation will trend up over the next five years). Chart 6DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up Chart 7All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs The Fed, therefore, will not be in a rush to raise rates. It does not see the labor market as anywhere close to “maximum employment” – it has not defined what it means by this, but we would see it as a 3.8% unemployment rate (the median FOMC dot for the equilibrium unemployment rate) and the prime-age participation rate back to its 2019 level (Chart 8). We continue to expect the first rate hike only in December next year. The Fed will feel the need to override its employment criterion only if long-term inflation expectations become unanchored – but the 5-year 5-year forward breakeven rate is only at 2.3%, within the Fed’s effective CPI target range of 2.3-2.5% (Chart 5). We remain comfortable with our view of only a moderate rise in long-term rates, with the US 10-year Treasury yield at 1.7% by end-2021, and reaching 2-2.25% at the time of the first Fed rate hike. It is also worth emphasizing that even a fairly sharp rise in long-term rates has historically almost always coincided with strong equity performance (Chart 9 and Table 2). This has again been evident in the past 12 months: When rates rose between August 2020 and March 2021, and then from July 2021, equities performed strongly. Chart 8We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" Chart 9Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market   Table 2Episodes Of Rising Long-Term Rates Since 1990 Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks But could the economy get too cold? We would discount the weak US GDP reading: It was mostly due to production shortages, especially in autos, which pushed down consumption on durable goods by 26% QoQ annualized, and by some softness in spending on services due to the delta Covid variant, the impact of which is now fading. US growth should continue to be supported by a combination of the $2.5 trillion of excess household savings, strong capex as companies boost their production capacity, and a further 5% of GDP in fiscal stimulus that should be passed by Congress by year-end. Similar conditions apply in other developed economies. Chart 10Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP We see three principal risks to this positive outlook: A new strain of Covid-19 that proves resistant to current vaccines – unlikely but not impossible. Our geopolitical strategists worry about Iran, which may have a nuclear bomb ready by December, prompting Israel to bomb the country. Iran would likely react by hampering oil supplies, even blocking the Strait of Hormuz, through which 25% of global oil flows. Chinese growth has been slowing and the impact from the problems at Evergrande is still unclear. Real estate is a major part of the Chinese economy, with residential investment comprising 10% of GDP (Chart 10) and, broadly defined to include construction and building materials, real estate overall perhaps as much as one-third. Our China strategists don’t expect the government to launch a major stimulus which would bail out the industry, since it is happy with the way that property-related lending has been shrinking in recent years (Chart 11). We expect the slowdown in Chinese credit growth to bottom out over the coming few months, but economic activity may have further to slow (Chart 12), and there is a risk that the authorities are unable to control the fallout from the property market. Chart 11Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chart 12When Will Credit Growth Bottom? When Will Credit Growth Bottom? When Will Credit Growth Bottom?       Fixed Income: Given the macro environment described above, we remain underweight bonds and short duration. If we assume 1) a Fed liftoff in December 2022, 2) 100 basis points of rate hikes over the following year, and 3) a terminal Fed Funds Rate of 2.08% (the median forecast from the New York Fed’s Survey of Market Participants), 10-year US Treasurys will return -0.2% over the next 12 months, and 2-year Treasurys +0.3%.1 TIPs have overshot fair value and, although we remain neutral since they a tail-risk hedge against high inflation over the next five years, we would especially avoid 2-year TIPS which look very overvalued. We see some pockets of selective value in lower-quality high-yield bonds, specifically US Ba- and Caa-rated issues, which are still trading at breakeven spreads around the 35th historical percentile, whereas higher-rated bonds look very expensive (Chart 13). For US tax-paying investors, municipal bonds look particularly attractive at the moment, with general-obligation (GO) munis trading at a duration-matched yield higher than Treasurys even before tax considerations (Chart 14). Our US bond strategists have recently gone maximum overweight. Chart 13 Chart 14Muni Bonds Are A Steal Muni Bonds Are A Steal Muni Bonds Are A Steal     Equities: We retain our longstanding preference for US equities over other Developed Markets. US equities have outperformed this year, irrespective of whether rates were rising or falling, or how US growth was surprising relative to the rest of the world, emphasizing the much stronger fundamentals of the US market (Chart 15).  Analysts’ forecasts for the next few quarters look quite cautious, and so earnings surprises can push US stock prices up further (Chart 16). We reiterate the neutral on China but underweight on Emerging Markets ex-China that we initiated in our latest Quarterly. Our sector overweights are a mixture of cyclicals (Industrials), rising-interest-rate plays (Financials), and defensives (Heath Care). Chart 15US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened Chart 16Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters   Currencies: We continue to expect the US dollar to be stuck in its trading range and so stay neutral. Recent moves in prospective relative monetary policy bring us to change two of our currency recommendations. We close our underweight on the Australian dollar. The recent rise in Australian inflation (with both trimmed mean and 10-year breakevens now above 2% – Chart 17) has brought forward the timing of the first rate hike and should push up relative real rates (Chart 18). We lower our recommendation on the Japanese yen from overweight to neutral. The Bank of Japan will not raise rates any time soon, even when other central banks are tightening. This will push real-rate differentials against the yen (Chart 18, panel 2). Chart 17Australian Inflation Is Picking Up Australian Inflation Is Picking Up Australian Inflation Is Picking Up Chart 18Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Chart 19Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Commodities: We remain cautious on those industrial metals which are most sensitive to slowing Chinese growth and its weakening property market. The fall in iron ore prices since July is now being followed by aluminum. However, metals which are increasingly driven by investment in alternative energy, notably copper, are likely to hold up better (Chart 19). We are underweight the equity Materials sector and neutral on the commodities asset class. The Brent crude oil price has broadly reached our energy strategists’ forecasts of $80/bbl on average in 2022 and $81 in 2023 (Chart 20). Although the forward curve is lower than this, with December-22 Brent at only $75/bbl, it is a misapprehension to characterize this as the market forecasting that the oil price will fall. Backwardation (where futures prices are lower than spot) is the usual state of affairs for structural reasons (for example, producers hedging production forward). The market typically moves to contango only when the oil price has fallen sharply and reserves are high (Chart 21). We remain neutral on the equities Energy sector.   Chart 20Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Chart 21Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation  

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