Consumer

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast series ‘Where Is The Groupthink Wrong?' I do hope you can join. Executive Summary Spending on goods is in freefall while spending on services is struggling to regain its pre-pandemic trend.  If spending on goods crashes to below its previous trend, then there will be a substantial shortfall in demand. The good news is that the freefall in goods spending is leading inflation. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year. Underweight the goods-dominated consumer discretionary sector, and underweight semiconductors versus the broader technology sector. Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Overbought base metals are particularly vulnerable. Fractal trading watchlist: We focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Bottom Line: As spending on goods crashes back to earth, so will inflation, consumer discretionary stocks, semiconductors, and overbought commodities. Feature The pandemic has unleashed a great experiment in our spending behaviour. After a binge on consumer goods, will there be a massive hangover? We are about to find out. The pandemic binge on consumer goods, peaking in the US at a 26 percent overspend, is unprecedented in modern economic history. Hence, we cannot be certain what happens next, but there are three possibilities: We sustain the binge on goods, at least partly. Spending on goods falls back to its pre-pandemic trend. There is a hangover, in which spending on goods crashes to below its previous trend. The answer to this question will have a huge bearing on growth and inflation in 2022-23. After The Binge Comes The Hangover… The pandemic’s constraints on socialising, movement, and in-person contact caused a slump in spending on many services: recreation, hospitality, travel, in-person shopping, and in-person healthcare. Nevertheless, with incomes propped up by massive stimulus, we displaced our spending to items that could be enjoyed within the pandemic’s confines; namely, goods – on which, we binged (Chart I-1). Chart I-1Spending On Goods Is In Freefall Spending On Goods Is In Freefall Spending On Goods Is In Freefall Gradually, we learned to live with SARS-CoV-2, and spending on services bounced back. At the same time, we made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping. Additionally, a significant minority of people changed their behaviour, shunning activities that require close contact with strangers – going to the cinema or to amusement parks, using public transport, or going to the dentist or in-person doctors’ appointments. The result is that spending on services is levelling off well short of its pre-pandemic trend (Charts I-2-Chart I-5). Chart I-2Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Chart I-3Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Chart I-4Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Chart I-5Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Arithmetically therefore, to keep overall demand on trend, spending on goods must stay above its pre-pandemic trend. Yet spending on goods is crashing back to earth. The simple reason is that durables, by their very definition, are durable. Even nondurables such as clothes and shoes are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can binge on before reaching saturation. Indeed, to the extent that our bingeing has brought forward future purchases, the big risk is a period of underspending on goods. Countering The Counterarguments Let’s address some counterarguments to the hangover thesis. One counterargument is that some goods are a substitute for services: for example, eating-in (food at home) substitutes for eating-out; and recreational goods substitute for recreational services. So, if there is a shortfall in services spending, there will be an automatic substitution into goods spending. The problem is that the substitutes are not mirror-image substitutes. Spending on eating-in tends to be much less than on eating-out. And once you have bought your recreational goods, you don’t keep buying them! A second counterargument is that provided the savings rate does not rise, there will be no shortfall in spending. Yet this is a tautology. The savings rate is simply the residual of income less spending. So, to the extent that there is a structural shortfall in services spending combined with a hangover in goods spending, the savings rate must rise – as it has in the past two months. A third counterargument is that the war chest of savings accumulated during the pandemic will unleash a tsunami of spending. Well, it hasn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-6). Chart I-6Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending Previous Episodes Of Excess Savings Had No Impact On Spending The explanation comes from a theory known as Mental Accounting Bias. This points out that we segment our money into different ‘mental accounts’. And that the main factor that establishes whether we spend our money is which mental account it resides in. The moment we move money from our ‘income’ account into our ‘wealth’ account, our propensity to spend it collapses. Specifically, we will spend most of the money in our ‘income’ mental account, but we will spend little of the money in our ‘wealth’ mental account. Hence, the moment we move money from our income account into our wealth account, our propensity to spend it collapses. Still, this brings us to a fourth counterargument, which claims that even though the ‘wealth effect’ is small, it isn’t zero. Therefore, the recent boom in household wealth will bolster growth. Yet as we explained in The Wealth Impulse Has Peaked, the impact of your wealth on your spending growth does not come from your wealth change. It comes from your wealth impulse, which is fading fast (Chart I-7). Chart I-7The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked The 'Wealth Impulse' Has Peaked Analogous to the more widely-used credit impulse, the wealth impulse compares your capital gain in any year with your capital gain in the preceding year. It is this change in your capital gain – and not the capital gain per se – that establishes the growth in your ‘wealth effect’ spending. Unfortunately, the wealth impulse has peaked, meaning its impact on spending growth will not be a tailwind. It will be a headwind. As Spending On Goods Crashes Back To Earth, So Will Inflation, Consumer Discretionary Stocks, And Overbought Commodities In the fourth quarter of 2021, US consumer spending dipped to below its pre-pandemic trend and the savings rate increased. Begging the question, how did the US economy manage to grow at a stellar 6.7 percent (annualised) rate? The simple answer is that inventory restocking contributed almost 5 percent to the 6.7 percent growth rate. In fact, removing inventory restocking, US final demand came to a virtual standstill in the second half of 2021, growing at just a 1 percent (annualised) rate. Growth that is dependent on inventory restocking is a concern because inventory restocking averages to zero in the long run, and after a massive positive contribution there tends to come a symmetrical negative contribution. If, as we expect, spending on services fails to catch up to its pre-pandemic trend while spending on goods falls back to its pre-pandemic trend, then there will be a demand shortfall. And if there is a hangover, in which spending on goods crashes to below its previous trend, then the demand shortfall could be substantial. As inflation crashes back to earth, so will overbought commodities. The good news is that the freefall in durable goods spending is leading inflation. In this regard, you might be surprised to learn that the US core (6-month) inflation rate has already been declining for five consecutive months. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year (Chart I-8). Chart I-8As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation As Spending On Goods Crashes Back To Earth, So Will Inflation Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Given that the level (rather than the inflation) of commodity prices is irrationally tracking the inflation rate, the likely explanation is that investors have piled into commodities as a hedge against inflation. Hence, as inflation crashes back to earth, so will overbought commodities (Chart I-9). Overbought base metals are particularly vulnerable. Chart I-9Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Overbought Commodities Are Particularly Vulnerable Fractal Trading Watchlist This week we focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. To reiterate, overbought base metals are vulnerable, and the 70 percent outperformance of nickel versus silver through the past year has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2016, 2018, and 2020 (Chart I-10). Accordingly, this week’s recommended trade is to go short nickel versus silver, setting the profit target and symmetrical stop-loss at 20 percent.  Chart I-10Short Nickel Versus Silver Short Nickel Versus Silver Short Nickel Versus Silver A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell CAD/SEK Approaching A Sell EUR/CZK At A Bottom EUR/CZK At A Bottom EUR/CZK At A Bottom Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... After The Pandemic Binge Comes The Pandemic Hangover... 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations      

Highlights The combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency for the Fed to raise interest rates. The central bank’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, and it will move forward with a rate hike at its March meeting. We expect that the Fed funds rate will rise to 1% by the end of this year. The Fed’s asset purchase reductions will not have a direct impact on economic activity, but they could have an indirect effect by prompting a faster rise in US Treasury yields towards their fair value levels. The US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year, rather than by the end of 2022 as we previously expected. Part of the generalized rise in risk premia this month relates to the potential Russian invasion of Ukraine, but the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates. Rising long-maturity bond yields are being driven by the short end of the curve, which we see as a sign that the generalized selloff in the US equity market is uncalled for. Investors should buy the US stock market at current levels on a 6-12 month time horizon. It is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. A Russian invasion of Ukraine has become a likely event, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but investors should gird for a risk-off reaction over shorter-term time horizons. Omicron, The Supply-Side, And The Fed January was a poor month for the global equity market, which sold off 10% from its high at the beginning of the year. Chart I-1 highlights that in the US, the S&P 500 has now fallen below its 200-day moving average, in contrast to global ex-US stocks which have fared somewhat better in US$ terms. Equities have declined this month because of a combination of imminent Fed tightening and a geopolitical crisis, both of which we will discuss in detail below. On the pandemic front, the number of confirmed cases of COVID-19 has surged globally (Chart I-2), which is likely an underestimation of the total number of infections given capacity limits on testing in many countries. Panel 2 highlights that services PMIs fell sharply in January in several economies because of the Omicron wave, reflecting both renewed pandemic control measures in some countries as well as precautionary changes in behavior amongst consumers in countries where widespread “non-pharmaceutical interventions” (“NPIs”) were not reintroduced. Manufacturing PMIs, on the other hand, held up quite well, even in Europe where natural gas prices remain high. Chart I-1A Significant Correction In US Stock Prices A Significant Correction In US Stock Prices A Significant Correction In US Stock Prices Chart I-2Omicron Is Impacting Services, Not Manufacturing Omicron Is Impacting Services, Not Manufacturing Omicron Is Impacting Services, Not Manufacturing   Some positive signs have emerged from the hospitalization data in advanced economies, as they appear to be pointing to a cresting wave of patients with COVID-19 both in hospitals overall and specifically in intensive care units (Chart I-3). The evolution of the pandemic remains highly uncertain, and the development of new variants continues to remain a risk. But incoming data on hospitalizations, the rapid increase in the number of vaccine booster doses administered in many advanced economies, and the sheer speed at which the disease has recently been spreading all point to a possible imminent peak in the impact of the Omicron variant on the demand side of the economy – at least in the developed world. However, Chart I-4 highlights that there is no sign yet of a waning impact of the pandemic on the supply side of the economy. The chart shows that rising European natural gas prices are having less of an impact on our supply-side pressure indicator, but that the indicator remains flat excluding this effect. We noted in last month’s report that the Omicron variant posed a significant risk of more frequent or longer lockdowns in China, because of the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to provide any protection against contracting Omicron. Panel 2 of Chart I-4 highlights that shipping costs between China/East Asia and the west coast of the US have started to tick higher again, suggesting that the impact of ongoing lockdowns as well as mandatory quarantines and testing in key areas such as Shenzhen, Tianjin, Ningbo, and Xi’an may already be having an effect. Chart I-3Hospitalizations From Omicron Appear To Be Peaking Hospitalizations From Omicron Appear To Be Peaking Hospitalizations From Omicron Appear To Be Peaking Chart I-4Pandemic-Related Supply-Side Pressures Remain Severe Pandemic-Related Supply-Side Pressures Remain Severe Pandemic-Related Supply-Side Pressures Remain Severe   From the Fed’s perspective, a combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency to raise interest rates. The Fed’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, which is being partially driven by demand (even if supply-chain factors are also materially boosting global goods prices). Chart I-5The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year Chart I-5 shows that our inflation momentum model is signaling falling odds of 4% or higher core PCE inflation, but the model’s probability remains above the 50% mark. Thus, while it is possible that US inflation will soon peak in year-over-year terms, the Fed will move forward with a rate hike at its March meeting. For now, we believe that the Fed will move at a pace of four quarter-point rate hikes per year (regardless of how they are sequenced), suggesting that the effective Fed funds rate will rise to 1% by the end of this year. Quantitative Tightening And Financial Markets Investors continue to wrestle with the Fed’s recent hawkish shift and the implications that it may have for economic activity and financial markets. Investors are not just concerned about the pace and magnitude of Fed rate hikes, but also the potential impact of quantitative tightening as the Fed moves to slow the pace of its asset purchases over the coming few months. Chart I-6The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one In our view, investors should be more concerned with the former rather than the latter. Chart I-6 highlights the reason that investors were so focused on the magnitude of the Fed’s balance sheet during the first half of the last economic expansion. Panel 1 of the chart shows that the level of the S&P 500 correlated almost perfectly with the Fed’s total holdings of securities from 2008 to 2015. However, panel 2 highlights that this relationship broke down from 2016 to early 2020, only to correlate positively again as the Fed’s holdings of securities surged higher during the pandemic. To us, the experience of the past decade highlights that the correlation between the Fed’s balance sheet and the equity market is mostly a spurious one. The two are indirectly related; periods when the Fed’s security holdings increase reflect periods of monetary easing, which is typically positive for risky asset prices. But we do not agree that the impact of asset purchases on long-maturity bond yields can be effectively separated from the direct impact of changes in short-term interest rates, which are typically falling as the Fed’s balance sheet rises. In addition, asset purchases signal important information by the Fed about the future path of short-term interest rates when it changes the pace of its purchases. And finally, the 2016-2019 period strongly underscores that there is no direct link between Fed asset purchases and the stock market. It is possible that periods of rising Fed asset purchases are associated with a low government bond term premium or more dovish investor sentiment about the future path of interest rates than is projected by the Fed. If so, that could imply that the Fed’s asset purchase reductions will have some impact on financial markets over the coming months. Chart I-7 suggests that the term premium on 10-year Treasurys is no longer low, but these series are based on surveys of primary dealers and fixed-income market participants, and thus may not reflect the aggregate views of investors. Chart I-8 highlights that 10-year government bond yields are 40 basis points below the fair value implied by the Fed’s interest rate projections, and panel 2 highlights a similar conclusion based on a regression of the 10-year yield on the 2-year yield and 5-year/5-year forward CPI swap rates. Thus, it is possible that the Fed’s rapid reduction in the pace of its asset purchases will cause bond yields to converge quickly with these estimates of fair value, implying that the US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year rather than by the end of 2022, as we previously expected. Chart I-7Surveys Suggest The Term Premium Is No Longer Deeply Negative... Surveys Suggest The Term Premium Is No Longer Deeply Negative... Surveys Suggest The Term Premium Is No Longer Deeply Negative... Chart I-8...But 10-Year Treasury Yields Are Lower Than They Should Be ...But 10-Year Treasury Yields Are Lower Than They Should Be ...But 10-Year Treasury Yields Are Lower Than They Should Be The Stock Market, Interest Rates, And Value Versus Growth Chart I-9The US Equity Market Selloff Has Been Driven By Tech Stocks The US Equity Market Selloff Has Been Driven By Tech Stocks The US Equity Market Selloff Has Been Driven By Tech Stocks The fact that the global equity selloff had been concentrated in the US prior to the escalation in tensions over Ukraine reveals the root cause of the decline. Chart I-9 highlights that the Nasdaq has fallen more than the S&P 500, as have US growth stocks compared with value stocks. As such, the recent selloff in the stock market reflects some of the major themes that we presented in our 2022 annual outlook. We highlighted in our outlook, as well as several previous reports, that the relative performance of global growth versus value since the pandemic has been driven primarily by changes in valuation that could reverse if bond yields rose. Chart I-10 highlights that this is exactly what has occurred over the past month, which also explains the underperformance of US equities given how heavily-weighted the US market is toward broadly-defined technology stocks. However, the underperformance of US growth stocks has occurred within the context of a nontrivial decline in the overall US market, which was somewhat beyond our expectation. We anticipated a period of elevated financial market volatility in advance of the Fed’s first rate hike, and we warned investors that 2022 was likely to be a year of meaningfully lower total returns (mid-to-high single digits) compared with the past two years. The fact that equity multiples for growth stocks are falling in response to higher long-maturity bond yields is not surprising to us. But investors have punished both growth and value stocks as bond yields have risen, behavior that we do not think is justified given the large difference in valuation between the two. Chart I-11 highlights that our (standardized) proxy for the equity risk premium (ERP) is above its 2003-2021 average for value stocks, whereas it is quite low for growth stocks. Had the ERP for value stocks fallen to its historical average this month value stocks would have risen between 1-4% in January despite rising real 10-year government bond yields. And the historically average levels shown in Chart I-11 might themselves be too high, given that other ERP estimates like the ones we showed in our annual outlook highlight that the 2003-2021 period was one in which the US ERP was historically elevated. Chart I-10Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Chart I-11The ERP For Value Stocks Does Not Need To Rise The ERP For Value Stocks Does Not Need To Rise The ERP For Value Stocks Does Not Need To Rise Chart I-12The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks As noted, part of a generalized rise in the ERP this month relates to the potential Russian invasion of Ukraine, an event that we now see as likely (discussed below). But the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates, particularly given the (mistaken) perception amongst investors that Fed hawkishness is entirely driven by elevated inflation. We acknowledge that the Fed’s hawkish shift has been a rapid one, and that this has led US government bond yields to rise quickly. Both the level and change in interest rates matter for economic activity and financial market sentiment, but our view is that the former is more important. Changes in interest rates are mainly significant because they create uncertainty about where rates will ultimately settle, and whether that level would be sustainable for economic activity and the valuation of financial assets. In this respect, Chart I-12 should be encouraging for investors. The chart shows that the 10-year Treasury yield recently reached a new pandemic high, but that this rise was driven by yields on shorter-maturity bonds. 5-year/5-year forward Treasury yields remain 50 basis points below the Fed’s long-term Fed funds rate projection (2.5%), suggesting that the rapid move in US Treasury yields simply reflects a revised pace of rate hikes – not ultimately a higher level. This underscores that the generalized selloff in the US equity market is uncalled for, and that investors should buy the US stock market at current levels. Chart I-13Recession Fears May Rise Early Next Year Recession Fears May Rise Early Next Year Recession Fears May Rise Early Next Year Chart I-13 highlights that an accelerated pace of rate hikes will likely cause the yield curve to be flatter at the end of the year than would have otherwise been the case, which may eventually be interpreted by investors as a sign that a recession is drawing nearer (potentially implicating both value and growth stocks). We discussed this risk in last month’s report, but for now we maintain the view that this is more likely to occur in 2023 rather than this year. The chart highlights that the S&P 500 did not sell off in response to growth/recession concerns in 2018 before the 2/10 yield curve had flattened to 20-30 basis points, which isn’t likely to occur until 1H 2023 according to fair value calculations derived from the FOMC’s rate projections. The Dollar, Chinese Policy, Commodities, And Global Ex-US Stocks Chart I-14Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Despite the recent surge in US interest rate expectations, and up until last week, the US dollar had behaved in a somewhat strange fashion since late November– even as the Omicron variant spread rapidly around the globe. Chart I-14 highlights that the dollar had traded counter to both relative interest rate differentials and the intensity of the pandemic, both of which appear to have strongly explained the dollar’s trend in the first three quarters of 2021. As we go to press, the US dollar is rallying again, although at least some of the rise is being driven by the prospect of imminent war in Ukraine. We argued in our annual outlook that the dollar was likely to fall this year, and that it was both technically stretched and expensive according to our PPP models. Chart I-15 highlights that the prior weakness in the dollar may also be explained by slowing net foreign purchases of US equities, as the impact of global equity investors flocking to the tech-heavy US market during the pandemic begins to wane. However, we suspect that two additional factors may have been impacting the broad dollar trend before this week’s surge in geopolitical risk. The first is a possible reversal in the correlation between the number of COVID-19 cases and the dollar (from positive to negative). For most of the pandemic, investors have treated new waves of the pandemic as an indication that global growth will slow, which certainly occurred in the services sector this month. But the sheer speed at which the Omicron variant is spreading, in combination with the fact that it causes less severe disease than previous variants, has likely prompted some investors to expect that Omicron has shortened the amount of time to COVID-19 endemicity. An endemic disease, while still a public health issue, would imply less transmission and much less COVID-19-related hospitalization and death. Correspondingly, it would also likely be associated with a significant increase in services spending alongside stronger international travel, which would be positive for global growth (and thus negative for the dollar). Second, it is apparent that China-related assets have caught a bid, as illustrated by our market-based China growth indicator and its accompanying diffusion index (Chart I-16). While the indicators shown in Chart I-16 remain below the boom/bust line, they are rising quickly, and in a manner that suggests investors are reacting to new information. Chart I-15Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Chart I-16Since November, Optimism Towards China Has Also Likely Weakened The Dollar Since November, Optimism Towards China Has Also Likely Weakened The Dollar Since November, Optimism Towards China Has Also Likely Weakened The Dollar Chart I-17China Bulls Are Probably A Bit Too Early China Bulls Are Probably A Bit Too Early China Bulls Are Probably A Bit Too Early We doubt that investors would be upgrading their outlook for Chinese economic growth based on expectations of COVID-19 endemicity, given the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to prevent transmission of Omicron. Therefore, we conclude that investors have become more optimistic about the pace of easing from Chinese policymakers, potentially sparked by a recent pickup in the pace of special purpose local government bond issuance (Chart I-17). We agree with investors that Chinese monetary policy is becoming easier at the margin. For example, the PBoC recently reduced its one-year loan prime rate (LPR) by 10 bps and five-year rate by 5 bps, following last week’s 10bps cut in the 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rate. This is on top of December’s 50 bps drop in the reserve requirement ratio (RRR). But we do not think that China’s credit data is yet heralding a meaningfully stronger growth impulse. Panel 2 of Chart I-17 presents the 12-month flow of China’s ex-equity total social financing as a share of nominal GDP, both including and excluding local government bond issuance. The chart highlights that the significant pickup in local government bond issuance has led to only a slight uptick in China’s overall credit impulse. Excluding local government bonds, China’s credit impulse continues to decline, reflecting an impaired monetary policy transmission mechanism and slowing bank loan growth. The implication is that it is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. At least some of the pickup in our market-based indicator reflects passive outperformance of some China-sensitive assets; Chart I-18 highlights that global ex-stocks and industrial metals prices have risen relative to US stock prices over the past month, but mostly because US stocks sold off in reaction to Fed hawkishness. Chart I-19 highlights that industrial metals prices continue to advance in a fashion that is not explained by the pace of China’s credit growth (as has generally been the case over the past decade), suggesting that metals are being somewhat supported by investment demand that is likely being driven by inflation hedging. We noted in our November Special Report that industrial commodities performed well during the stagflationary period of the 1970s,1 and over the past 40 years during months in which stock and bond returns are both negative. This makes metals an ideal portfolio hedge in the current environment, and we suspect that this factor – in addition to global inventory drawdowns last year – have kept prices elevated. Chart I-18Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Chart I-19Metals Prices Are Higher Than What Chinese Economic Growth Would Imply Metals Prices Are Higher Than What Chinese Economic Growth Would Imply Metals Prices Are Higher Than What Chinese Economic Growth Would Imply However, this also implies that metals prices could sell off at some point over the coming few months if US inflation fears begin to peak and Chinese monetary policy has not yet turned decisively reflationary. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. Similarly, while we believe that investors should maintain global ex-US stocks on upgrade watch, we would prefer to see more evidence of a likely acceleration in Chinese economic activity before upgrading. In addition, we would also recommend that investors wait for the Ukrainian situation to play out, given the recent selloff in European stocks in response to the deepening crisis. A Likely War In Ukraine Last week, US President Joe Biden publicly predicted that Russia would likely invade parts of Ukraine, and implied that the sanction response from Western countries might be muted if the invasion were “minor”. Biden’s remarks have since been described as a gaffe, but in our view they were likely accurate. When combined with reports that the White House is warning domestic chipmakers of potential export restrictions to Russia in the event of an invasion, Biden’s remarks suggest that the US government does not believe that a diplomatic solution is likely and that Russia will probably send troops into Ukrainian territory. A full-scale invasion of Ukraine is very unlikely, as it would unite the Western world in delivering crippling economic sanctions towards Russia. The question for investors is whether the economic consequences of a minor incursion have significant enough implications to change one’s 12-month asset allocation stance. The extent of the rise in energy prices following a minor Russian incursion into Ukraine would be the key determinant of the impact that Russian military action would have on financial markets. Russia could withhold natural gas or oil exports to punish Europe if the Nord Stream II pipeline were cancelled. Oil prices would likely rise, even if retaliatory action was limited to the natural gas market, because oil consumption would rise as a substitute. This would further exacerbate the European energy crisis, although as we noted above, the PMI data continues to point to COVID as a more serious near-term threat to European economic activity than energy prices. Our geopolitical strategy team recently upgraded the odds of Russia invading Ukraine from 50% to 75%, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but it is likely to have a near-term impact on the performance of some assets. While some of the risk of this event has already been priced in, on a 0-3 month time horizon, the US dollar would likely rally even further in response to an invasion and we suspect that the recent outperformance of global ex-US stocks would reverse (with the US outperforming). Our sense is that global equities may underperform government bonds for a short period following a minor incursion, but that a more aggressive Russian invasion would likely be needed to cause a persistent rise in the US dollar, US equity outperformance, and stocks to underperform bonds on a 12-month time horizon. Investment Conclusions Chart I-20We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio Relative to the investment positions that we presented in our annual outlook report, we see no compelling reason to alter any of our recommendations on a 6-12 month time horizon. Over the nearer-term, a minor Russian incursion of Ukraine is now likely, and may further roil financial markets for a period of time. But the bar for the Ukrainian situation to durably impact returns on a 12-month time horizon is high, and implies a degree of conflict that we do not currently expect. US equities have sold off because of a rise in the discount rate and in the equity risk premium. We do not believe the latter is justified for the market as a whole. Our view that US equities have overreacted to the Fed’s hawkish shift and that long-maturity US bond yields have roughly another 50 basis points of upside this year strongly point to an overweight stance towards stocks versus bonds and a short-duration stance as still justified. We continue to expect that growth stocks will underperform value stocks over the coming year, but in the context of a rising rather than falling overall market (Chart I-20). It is too early to position aggressively toward China-sensitive commodities and global ex-US stocks, but investors should maintain these assets on upgrade watch. The US dollar may continue to reverse some of its recent decline over the coming 3 months in response to military conflict in Ukraine or if investors dial back their expectations for Chinese economic growth, but we expect a lower dollar in a year’s time. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2022 Next Report: February 24, 2022 II. The US Productivity Surge: Less Than Meets The Eye The current surge in US measured productivity looks very unlike what occurred in the mid-to-late 1990s. A detailed breakdown of labor productivity growth points to atypical labor market compositional effects – namely a significant decline in services employment – as being responsible for the apparent rise in productivity. In addition, technological disinflation, a major ingredient of the late 1990s “disinflationary boom”, is absent today. A cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the crisis. US output per worker surged compared to other countries, but the US fiscal response also generated a significant amount of excess income to support economic activity – unlike in the euro area, UK, and Japan. Micro-level arguments and some academic studies argue against the idea that work from home arrangements will ultimately be productivity-enhancing. Remote work makes it more difficult for firms to train the next generation of senior employees, which will raise the staffing risks for many businesses. While the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. If inflation remains significantly above target after the pandemic is over, the Fed’s long-term interest rate projections may rise. US stocks would suffer potentially large losses in a scenario where 10-year US Treasury yields rise towards the potential growth rate of the economy. Investors should consider reducing their equity exposure if 5-year, 5-year forward US Treasury yields break above 2.5%. We do not expect that to occur this year, which for now justifies an overweight stance towards risky assets. Chart II-1A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge? A Pandemic-Driven Productivity Surge? The behavior of US labor productivity during the COVID-19 pandemic has raised several questions among investors. As defined by output per hour worked, US productivity accelerated significantly over the first six quarters of the COVID-19 pandemic, but then fell sharply in Q3 2021 (Chart II-1). While some market participants have questioned the cause of the recent decline, investors have generally been more interested in the question of whether the US is in the middle of a long-lasting productivity surge that will help alleviate inflationary pressure – akin to what occurred in the second half of the 1990s. In this report, we review the recent surge in US labor productivity in contrast to what occurred in the late-1990s, and then compare it with what has occurred globally. While we are not pessimistic about the pace of technological advancement and its potential to drive long-run productivity, we conclude that the US is not likely experiencing a sustained productivity boom driven by technological adoption during the pandemic. This underscores why investors should not expect a significant increase in potential output owing to the pandemic or its effects. It also highlights that, if elevated inflation in response to strongly positive output gaps were to occur over the coming few years, it would likely be met by significantly tighter fiscal or monetary policy. Today Versus The 1990s: Total Factor Productivity Versus Capital Intensity Chart II-2The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event A technologically-driven surge in productivity growth in the second half of the 1990s was a highly significant macroeconomic event. Chart II-2 highlights that US labor productivity surged to over 3% from 1995 to 2000, alongside a significant deceleration in core PCE inflation and a sizeable acceleration in potential GDP growth. Given the acceleration in measured productivity during the pandemic, and the accompanying rapid adoption (or broader use) of technology, it is easy to see why some investors have questioned whether a 1990s-style productivity boom is underway. However, a detailed breakdown of the 2020 rise in labor productivity growth highlights substantial differences between the current environment and that of the late 1990s, which points instead to compositional effects as the main driver. Improvements in labor productivity can come from smarter workers, an increase in the amount of capital employed per worker, or from technological innovations and better working practices. The US Bureau of Labor Statistics provides a breakdown of the annual change in labor productivity that attempts to capture these three components: The contribution from shifts in labor composition: This measures the productivity impact of changes in the age, education, and gender structure of the labor force. The contribution from capital intensity: This measures the productivity impact of shifts in the amount of capital equipment available per worker. Total factor (or “multifactor”) productivity: This measures the changes in output per hour that cannot be accounted for by the above two factors. Thus, it includes the effects of technological changes, returns to scale, shifts in the allocation of resources, and other changes in operating procedures. Examining the 2020 rise in labor productivity growth along these three factors underscores key differences between the current environment and that of the late 1990s. The first point for investors to note is that the acceleration in labor productivity in 2020 occurred alongside a contraction in total factor productivity (TFP) growth, in contrast to the 1990s when TFP drove labor productivity (Chart II-3). The fact that TFP growth fell in 2020 means that the increase in labor productivity must have occurred either because of labor composition or capital intensity effects. In 2020, labor composition contributed somewhat to accelerating labor productivity, but that most of the increase was caused by a sharp increase in capital intensity. Some of the increase in overall capital intensity occurred because of an increase in the intensity of information processing equipment and intellectual property products (supporting the idea of an increase in pandemic-driven capital deployment), but this was outstripped by the contribution of “other” capital services (Chart II-4). Chart II-3Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Chart II-4The Surge In US Capital Intensity Reflects A Rapid Compositional Shift In The Labor Market February 2022 February 2022 The concept of capital intensity refers to the amount of capital available per worker, but in practice it is measured as the ratio of the amount of capital used relative to the amount of labor hours used to produce output. Thus, a surge in capital intensity that is not accounted for by an increase in the amount of tech-related capital available to workers points to a rapid compositional shift in the economy from relatively low capital-intensive industries to relatively high-intensive industries. Under less extreme economic circumstances we would be more inclined to search for other potential causes of a rapid increase in measured capital intensity, but a shift in employment from less to more capital-intensive industries is exactly what has occurred during the pandemic. Services jobs tend to be much more labor-intensive than goods-producing jobs; Chart II-5 highlights that the former fell far more than the latter during the pandemic, in sharp contrast to what normally occurs during a recession (Chart II-6). This phenomenon is also reflected in a highly unusual decline in services spending compared with very strong goods spending relative to their pre-pandemic trend. Chart II-5Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Chart II-6The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The takeaway for investors is that the nature of the pandemic and its unique impact on the economy has created the appearance of an acceleration in productivity, when in reality true productivity has fallen and the standard measure of productivity is being flattered by enormous changes in the composition of the labor market. Today Versus The 1990s: IT Investment, And Technological Disinflation The trends in IT investment and prices highlight another major difference between the current environment and that of the late 1990s. Charts II-7 and II-8 highlight recent trends in comparison to those of the 1990s, with the following notable points: Chart II-7There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s There Are Major Differences Between IT Investment And Prices Today Versus The 1990s Chart II-8A One-Off Move A One-Off Move A One-Off Move The recent pace of real investment in total IT does not point to the pandemic as a sustained source of productivity growth. Real investment in IT has already slowed significantly, in contrast to the 1990s when it accelerated on a sustained basis for years. IT investment as a % of GDP and of total plant and equipment spending has already stopped rising (or is now falling), exhibiting clear signs of a one-off shift and thus undermining the view that IT investment has significantly raised potential output. In pronounced contrast to the mid-1990s when IT equipment prices were collapsing, computing equipment inflation has recently risen into positive territory – to the highest levels recorded since the data became available in 1959. Higher prices for IT equipment clearly reflect, at least in part, pandemic-driven pressure on global supply chains and the production of semiconductors. So we do not expect sustained increases in the price of computing equipment. But the key point for investors is that a major ingredient of the late 1990s “disinflationary boom” is missing today. The US Versus The World We have presented Chart II-9 in previous reports to highlight that there is certainly no evidence of a global productivity surge, using output per worker as a proxy for the standard measure of labor productivity (output per hour worked). Some investors have countered that the US is a more dynamic economy, and that a sustained productivity boom would be more apparent in the US prior to its emergence in other countries. Or simply that the US alone is experiencing a productivity boom that will help reduce very elevated US inflation, with strong implications for Fed policy. Chart II-9During The Pandemic, Cross-Country Changes In Real Output Per Worker… February 2022 February 2022 Chart II-10…Are Mostly Explained By Different Fiscal Responses February 2022 February 2022 Chart II-11High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels Charts II-10 and II-11 present a different cross-country comparison that reinforces the view that the US is not likely experiencing a long-lasting productivity surge that will help reduce inflation. Chart II-10 highlights that in the face of a significant decline in employment, US output was supported by a substantial amount of “excess income” – the cumulative amount of household disposable income earned over the course of the pandemic in excess of what would have been predicted based on the pre-pandemic trend. Other major DM economies (such as the UK and euro area) either saw negative excess income or a modestly positive amount (Japan), underscoring that the fiscal response to the pandemic in most advanced economies was aimed at stabilizing income rather than raising it. In combination with Chart II-11 – which highlights that the US labor market recovery has significantly lagged behind the European and Canadian economies in terms of returning to the pre-pandemic employment trend – this would appear to explain why the US has experienced stronger real output per worker than other countries. Chart II-12Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Canada stands out as the outlier compared with the US, in the sense that it’s growth in real output per worker has been much lower but Canadian fiscal policy created a similar amount of excess income. However, it may be the case that the Canadian experience highlights that the US labor market recovery is the outlier, which could imply that the surge in US labor productivity may in fact have inflationary rather than disinflationary consequences at the margin. We discussed the factors that we believe are driving the slow recovery in the US working-age population in our 2022 annual outlook report, and how they are strongly linked to the pandemic. However, Canada has also clearly been affected by COVID-19, and yet it has experienced a more significant recovery in jobs. Chart II-12 highlights that there has been one major difference between the US and Canada during the pandemic: a substantial gap in the burden of disease from COVID-19. This raises the question of whether Canada has outperformed the US in terms of its labor market recovery, despite a similarly impactful fiscal response, because of a smaller labor shortage stemming from long-term COVID symptoms. Over the past two years, there have been many reports about people who have recovered from COVID but who continue to experience some symptoms of the disease. The medical community has labeled this condition as post-acute sequelae of SARS-CoV-2 infection (PASC), colloquially referred to as “long COVID.” Chart II-13Long-COVID Might Help Explain The US’ Lagged Return To Pre-Pandemic Employment February 2022 February 2022 The medical community’s understanding of long COVID is currently poor, and doctors do not know why some people get the condition or what treatment options are likely to be the most effective. Given this, it is possible that some reports of long COVID are, in fact, related to other conditions. But a recent research report from Brookings estimated that the US labor market may be missing 1.6 million workers because of long COVID’s effects (Chart II-13), which alone would account for 1 percentage point (or roughly 1/4th) of the growth in US real output per worker since the pandemic began. This circumstance would be inflationary rather than disinflationary on the margin, as it would imply that accelerating first and second quartile US wage growth may be sticky even as the pandemic recedes. Is Working From Home Positive For Productivity? We have noted above that the macro data argues against the idea of a sustained rise in US productivity stemming from the pandemic. A more micro-level perspective, one that examines the working-from-home (WFH) experience, also appears to support our case. It is true that surveys of employees highlight that their experience of WFH has been significantly better on average than workers expected and report their being more productive while working from home during the pandemic. Chart II-14 emphasizes that, based on the running surveys from Barrero, Bloom, and Davis (“BBD”), 60% of workers have conveyed better WFH outcomes relative to expectations, versus just 14% reporting worse outcomes. In addition, Chart II-15 clearly highlights that workers prefer at least some form of hybrid WFH arrangement, with just 22% of survey respondents reporting the desire to work from home either rarely or never. Chart II-14Remote Workers Have Reported Better Work-From-Home Outcomes Than What Was Expected February 2022 February 2022 Chart II-15Remote Workers Clearly Prefer A Hybrid Work Model February 2022 February 2022 However, worker preferences do not necessarily correlate with productivity gains, at least not to the same degree. Chart II-16 from the BBD surveys highlights that the share of workers reporting more efficiency while working from home is not as large as those reporting better outcomes relative to expectations, suggesting that employees are considering whether WFH arrangements are benefiting them personally when responding to their desired post-pandemic level of remote work. Chart II-17 also shows that employees working from home only spend a third of the time ordinarily allocated to commuting to working on their primary job; the rest is spent on childcare, leisure, home improvement, or working on a second job (which may or may not be a sustainable source of income). Chart II-16Less Than Half Of Workers Report Being More Efficient While Working Remotely February 2022 February 2022 Chart II-17Only 1/3rd Of Time Saved Commuting Is Spent On Primary Employment February 2022 February 2022 There is also some evidence from academic studies that indicates productivity fell during the pandemic for some remote workers. Michael Gibbs, Friederike Mengel, and Christoph Siemroth (2021) surveyed 10,000 professionals at a large Asian IT services company, and found that productivity declined because of a slight decline in average output and a rise in hours worked.2 Admittedly, elements of the study did point to some factors potentially impacting this decline in productivity that were more prominent in the earlier phase of the pandemic, specifically the issue of childcare (which would not likely be a drag on remote worker productivity in a post-pandemic environment). But it also noted that employees with a longer company tenure fared better, which in our view is an often overlooked element of remote work that points to less future productivity gains from WFH arrangements than may be recognized by investors. The outperformance of senior staff in a WFH environment is not particularly surprising: once employees have accrued significant experience, they spend less of their working time learning and more (or all) of their working time “doing.” It makes sense that employees who predominantly “platform” their existing experience may fare the same or better in a WFH arrangement, but it is highly questionable whether it is sustainable, because it makes it much more difficult for businesses to train the next generation of senior employees. The Gibbs, Mengel, and Siemroth study noted that higher communication and coordination costs featured prominently in their findings of reduced remote worker productivity. Importantly, they found that employees communicated with fewer individuals and business units, both inside and outside the firm, and received less coaching and one-to-one meetings with supervisors. While some firms may be able to mitigate these risks to the advancement and development of more junior staff while maintaining a hybrid on-site / WFH model, we suspect that many firms will fail to do so fully. Future Productivity: Pessimism Unwarranted, But No Inflation Salvation The fact that the US is not likely in the middle of a pandemic-driven productivity boom does not mean that the outlook for productivity is poor. In fact, we would point to two factors that lead us to believe that productivity growth will be better in the future than it has been over the past decade: The pronounced consumer deleveraging phase that existed for several years following the global financial crisis is over, and There are several identifiable technologies currently under development that are likely to have legitimate commercial applications and productivity-enhancing benefits in the future On the first point, we have contended in previous reports that the weak productivity growth observed during the first half of the last economic expansion was because of demand rather than supply-side factors. This notion is jarring for many investors, who are accustomed to think of productivity trends as being exclusively driven by supply-side phenomena. This is typically correct, in that the cyclical impact of fluctuating aggregate demand on measured productivity – particularly during and immediately after recessions – is usually temporary in nature. However, the 2008/2009 recession was highly atypical, in the sense that it was a household “balance sheet” recession rather than a normal “income” recession. This led to a prolonged period of US household deleveraging, below-average corporate sales growth, and poor growth in output per hour worked. In effect, the post-2008 deleveraging phase created a long-lasting, multi-year cyclical effect on measured productivity growth. In early-2009, pessimistic investors held to an understandable reason for why they doubted the sustainability of the economic recovery: there could be no meaningful labor market recovery if businesses expected several years of weak demand because of the likelihood of consumer deleveraging. In this respect, the post-2008 period served as an important natural experiment for macroeconomists and investors: we have learned that the response of firms to a durable but shallow economic recovery is, on the one hand, to hire additional workers, but, on the other hand, also to control wage and salary costs aggressively. Chart II-18Slow Productivity Growth Last Cycle Was A Demand Story, Not A Supply Story February 2022 February 2022 Chart II-18 encapsulates the point that weak productivity during the last economic cycle was closely tied to US household deleveraging. The chart highlights that the decline in total factor productivity due to goods-producing industries – heavily concentrated in manufacturing – was much larger than for private services from 2007 to 2019. Since there was no technological slowdown that disproportionally impacted the manufacturing industry during the period, this clearly points to demand-side rather than supply-side factors as the main driver of the post-GFC productivity slowdown. On the second point about future productivity growth, Table II-1 outlines five well-known technologies that are in various stages of development and are likely to lead to significant applications at some point in the future: artificial intelligence, automated driving (a specific application of AI), quantum computing, augmented/virtual reality and human-machine interface, and CRISPR/gene editing. The table outlines the nature of potential future applications, as well as projections from McKinsey Global Institute about the most likely commercialization timeline. Table II-1Technological Advancement Is Ongoing. It Won’t Likely Help Fight Inflation Over The Next Few Years February 2022 February 2022 A detailed analysis of each of these technologies is beyond the scope of this report, but Table II-1 underscores two key points for investors. The first is that further, technologically-driven productivity growth is not just possible, it is likely. It is clear what advancements will probably drive these productivity gains, and Table II-1 highlights only the most well-known technologies to which experts in the field would point to. The second point is that most major changes from these technologies are projected to occur beyond 2025, and, in many cases, beyond this decade. In the case of quantum computing, while it could potentially lead to an explosion of algorithmic power that would almost certainly have major commercial implications, it is even possible that this technology will initially subtract from total factor productivity growth before contributing positively. This is because of its potential to render much of the existing global internet security and privacy infrastructure useless, as highlighted by a NIST Cybersecurity White Paper last April: “Continued progress in the development of quantum computing foreshadows a particularly disruptive cryptographic transition. All widely used public-key cryptographic algorithms are theoretically vulnerable to attacks based on Shor’s algorithm, but the algorithm depends upon operations that can only be achieved by a large-scale quantum computer. Practical quantum computing, when available to cyber adversaries, will break the security of nearly all modern public-key cryptographic systems.”3 Some experts believe that the preparation required to avoid this outcome may dwarf that of the millennium bug (“Y2K”) problem of the late-1990s,4 which cost roughly 1% of GDP to fix – and thus was clearly not productivity-enhancing. The bottom line for investors is that while the long-term outlook for technologically-driven productivity growth is bright, it is unlikely to save the US and/or global economies from elevated inflation over the next several years if output gaps in advanced economies rise to strongly positive levels in the wake of the pandemic. Investment Conclusions Our analysis above has highlighted that the current surge in measured productivity looks very unlike what occurred in the mid-to-late 1990s, and that very atypical labor market compositional effects are likely responsible for the apparent rise in labor productivity. We have also highlighted that a cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the pandemic, and that there are micro-level arguments against the idea that work from home arrangements are productivity-enhancing. Finally, while the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. While we believe that the COVID-19 pandemic will recede in importance this year, it is not yet over. As such, investors do not yet know how strong the output gap in the US and other advanced economies will be on average over the coming two to three years, or what the pace of consumer price inflation will look like in the face of strong aggregate demand but substantially lower (or no) pressure from the supply-side of the economy (as we expect). Chart II-19There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates In a scenario in which aggregate demand remains strong next year and inflation remains above-target, even in the face of Fed tightening and a normalization in services/goods spending, we would expect to see significantly tighter fiscal or monetary policy. This is a scenario in which the secular stagnation narrative, which underpins the Fed’s low long-term interest rate projection, would likely be aggressively challenged by investors. Chart II-19 highlights that US equities would potentially suffer a 24% contraction in the forward P/E in a scenario in which the equity risk premium is in line with its historical average and 10-year US Treasury yields rise to the potential growth rate of the economy. We do not yet believe that a significant rise in long-term interest rate expectations will occur this year, meaning that investors should still be overweight stocks versus government bonds over the coming 6-12 months. But as we noted in last month’s report, we may recommend that investors reduce their equity exposure if 5-year, 5-year forward Treasury yields break above 2.5% (the FOMC’s long-run Fed funds rate projection), which we noted in Section 1 of our report is 50 basis points above current levels. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Content Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2     Michael Gibbs, Friederike Mengel, and Christoph Siemroth. “Work from Home & Productivity: Evidence from Personnel & Analytics Data.” Working Paper No. 2021-56. July 13, 2021. Pp. 1-30. 3    William Barker, William Polk, and Murugiah Souppaya. “Getting Ready for Post-Quantum Cryptography: Exploring Challenges Associated with Adopting and Using Post-Quantum Cryptographic Algorithms.” National Institute of Standards and Technology, US Department of Commerce. April 28, 2021. Pp. 1-7. 4    Jonathan Ruane, Andrew McAfee, and William Oliver. “Quantum Computing for Business Leaders.” Harvard Business Review, January-February 2022.

Highlights Federal Reserve: Market turbulence will not dissuade the Fed from starting to hike rates in March, with longer-term consumer inflation expectations climbing steadily higher. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Canada: Canadian growth is set to recover as the intense Omicron wave has peaked, further intensifying inflationary pressures. The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with inflation expectations above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates. Feature Chart of the WeekA Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets Risk assets have taken a beating over the past week, with major equity indices in the US and Europe suffering the sharpest selloffs seen since the early days of the pandemic. There are many sources of investor angst fueling the risk aversion wave - a potential Russian invasion of Ukraine, some mixed results on Q4/2021 corporate earnings reports, the lingering Omicron wave and most importantly, fears of tighter global monetary policy. The latter is most evident in the US, with a few prominent Wall Street investment banks now calling for the Fed to deliver much more than the 3-4 rate hikes currently discounted for 2022. The Fed is now in a difficult spot. Realized US inflation remains very high, supply chain disruptions are not going away, and wage growth is accelerating amid tight US labor market conditions. Survey-based consumer inflation expectations show little sign of peaking, with longer-term expectations now climbing steadily higher. As a result, the Fed has been forced to rapidly shift its policy guidance in a more hawkish direction. These trends are not unique to the US, however, as similar inflation dynamics are playing out in places like the UK and Canada where central banks are also expected to deliver a lot of monetary tightening this year (Chart of the Week). For inflation targeting central banks, a surge in inflation that becomes increasingly embedded in longer-term inflation expectations is a direct challenge to their credibility. The policy prescription must involve monetary tightening to raise real interest rates in a bid to stabilize inflation expectations. At the same time, given the starting point of near-0% nominal policy rates and high inflation, deeply negative real interest rates have a lot of room to rise before becoming a serious restraint on economic growth. This limits how far bond yields can decline in response to a generalized risk-off move like the one seen over the past week. For financial markets hooked on easy monetary policies, an inflation-induced monetary tightening cycle will lead to even higher bond yields – especially real yields - and more frequent bouts of market volatility this year. The events of the past week will likely not be a one-off. The Fed Cares About Inflation, Not Your Equity Portfolio US equity markets have had a rough start to 2022. The S&P 500 is down -9% so far in January, with the tech-heavy NASDAQ index down a whopping -13% (Chart 2). The VIX index now sits at 31, nearly double the level seen at the end of 2021. The selloff in risk assets has occurred alongside an increase in real US bond yields. TIPS yields for the 2yr, 5yr and 10yr maturities are up +20bps, +36bps and +43bps, respectively since the start of the year - a reflection of increasing Fed rate hike expectations. Yet other financial markets have seen more limited swings so far in 2022. Non-US equities are sharply outperforming the US; the EuroStoxx index of European equities is down -6%, while the MSCI emerging market (EM) equity index is down just -2%. US investment grade and high-yield spreads, using the Bloomberg benchmark indices, are up a relatively modest +9bps and +36bps, respectively, while the DXY US dollar index is up only +0.4%. The risk asset selloff seen year-to-date has been sharp, but has likely not been enough for the Fed to postpone the expected March liftoff of the fed funds rate. US financial conditions have tightened, but not nearly by enough to make the Fed to more concerned about the US economic growth outlook (Chart 3). Also, financial markets appear to be functioning normally, suggesting what is happening is a repricing of risk assets rather than a selloff driven by poor market liquidity conditions. Chart 2A 'Real' Equity Market Correction A 'Real' Equity Market Correction A 'Real' Equity Market Correction ​​​​​​ Chart 3High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern ​​​​​​ The bigger risk to US growth may actually come from high inflation, rather than falling asset values. Real US household income growth, derived from responses in the New York Fed’s Survey of Consumer Expectations to individual questions on incomes and inflation, is expected to contract -3% over the next year (bottom panel). Given that decline in perceived spending power, with inflation far exceeding wage growth, it is no surprise that the University of Michigan consumer confidence index is near an 8-year low. US business confidence has also been hit by high inflation. The NFIB survey of small business sentiment and the Conference Board survey of corporate CEO confidence declined in the latter half of 2021, largely in response to inflationary supply chain disruptions and labor shortages. Nearly one-quarter of NFIB survey respondents cite “inflation” as the single most important problem in operating their businesses. Economic sentiment has clearly taken a hit because of elevated US inflation, even with the US unemployment rate at 3.9% and overall real GDP growth remaining solidly above trend. This suggests that slowing inflation could actually provide a more sustainable boost to the US growth through improved confidence – if the Fed can first successfully engineer a “soft landing” for the economy once it begins hiking rates. The problem the Fed now faces is that the high inflation of the past year is starting to leak into longer-term survey-based measures of inflation expectations. 5-10 year ahead consumer inflation expectations from the University of Michigan survey are now at a 10-year high of 3.1%, while the 10-year-ahead inflation forecast from the Philadelphia Fed’s Survey of Professional Forecasters is at a 23-year high of 2.6% (Chart 4). Market-based inflation expectations like TIPS breakevens have stopped rising, as a more hawkish Fed has boosted real TIPS yields, but remain elevated at levels consistent with the Fed achieving, but not exceeding, it's 2% medium-term inflation target (bottom panel). The combination of a tight US labor market and consumers expecting more inflation raises the risk that the US could enter a wage-price spiral, where workers demand wage increases in response to higher inflation and companies are therefore forced to raise prices to maintain profitability. The conditions for a wage-price spiral seem to now be in place in the US (Chart 5): unemployment is low, wages are accelerating and a growing number of US workers are quitting jobs to find better work. Perhaps most importantly, US consumers are more uncertain about where inflation will be in the future. Chart 4US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched ​​​​​ Chart 5The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? ​​​​​​ The New York Fed Survey of Consumer Expectations asks respondents to place probabilities on certain ranges for future US inflation rates one and three years ahead. The probability-weighted average of those inflation rates is dubbed “inflation uncertainty”, and those have doubled over the past year from 2% to 4% (bottom panel). This means that the survey respondents now see higher inflation outcomes as more probable, which will likely result in increased wage demands to “keep up” with the cost of living. With the US labor market looking tight as a drum, amid extensive shortages of quality workers as reported in business confidence surveys, the odds of wage increases because of higher inflation instead of higher productivity – a.k.a. a wage-price spiral – have shot up significantly. Already, the 5-year-annualized growth rate of US unit labor costs has doubled since the start of the pandemic (Chart 6), evidence that wage increases are not being matched by faster productivity. Given the strong historical correlation between unit labor cost growth and core inflation in the US, the rise in the latter will be more persistent if US workers ask for bigger cost-of-living driven wage increases. Chart 6Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation ​​​​​​ Chart 7 ​​​​​ Former Fed Chair Alan Greenspan famously described “price stability” – the Fed’s stated medium-term goal - as a situation where “… households and businesses need not factor expectations of changes in the average level of prices into their decisions.” This is clearly not the situation in the US today, which is why the Fed has no choice but to move ahead with interest rate increases to begin the road back to price stability. Financial market selloffs may actually assist the Fed in achieving that goal through tighter financial conditions, thereby limiting how much interest rates must increase to cool off above-trend US economic growth. Interest rates must still go up first, though – especially in real terms. Already, investors have adjusted to that reality by lifting their medium-term “real rate expectations”. We proxy the latter by taking the difference between the forward path for nominal US interest rates discounted in the US overnight index swap (OIS) curve and the forward path of US inflation discounted in the US CPI swap curve. Over just the past month, that market-implied forward path for the real fed funds rate has shifted from discounting an average level of around -1% over the next decade to something closer to -0.25% (Chart 7). We anticipate that those real rate expectations will move even higher as the Fed begins to hike rates in March and continues its tightening cycle over the next 1-2 years. This will underpin the move higher in US bond yields that we expect this year, for both government and corporate debt, with the benchmark 10-year Treasury yield reaching a high of 2.25% by year-end. Bottom Line: Market turbulence will not dissuade the Fed from starting to hike rates in March. Longer-term consumer inflation expectations are climbing steadily higher, which is starting to feed into higher wage demands in a very tight labor market. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Stay below-benchmark on US interest rate exposure, both in terms of duration and country allocation, in global bond portfolios. Canada Update: The BoC Has A Lot Of Work To Do The Bank of Canada (BoC) meets this week and we anticipate that the first rate hike of this tightening cycle will be announced. This will just be the beginning of what will likely be an extended cycle. Canadian monetary conditions are far too accommodative given above-trend growth and accelerating inflation. The BoC places a lot of analytical weight on its Business Outlook Survey when assessing the state of the Canadian economy. The Q4/2021 survey signaled very strong business confidence and robust demand (both domestic and foreign), with a growing majority of firms surveyed planning to increase investment and hiring over the next year (Chart 8). Survey respondents also reported significant capacity constraints, especially in industries that have experienced strong demand during the pandemic, like retail, manufacturing and housing. This is related to global supply chain disruptions, but also to intensifying labor shortages. Chart 8A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy The survey was conducted before the Omicron variant began to spread through Canada, which lead to the reimposition of severe economic restrictions. The number of Canadian COVID cases has peaked, however, and some restrictions have already begun to be lifted in Ontario, Canada’s largest province by population. The economic impact of Omicron will therefore be concentrated in the first couple of months of 2022 and should not derail the hiring and investment plans indicated in the Business Outlook Survey. A reacceleration of Canadian economic growth post-Omicron would magnify high Canadian inflation at a time of intense capacity constraints and tight labor markets. The Canadian unemployment rate fell to 5.9% in December, just 0.2 percentage points above the pre-COVID low seen in February 2020. Headline CPI inflation reached a 31-year high of 4.8% in December 2021, with trimmed CPI inflation (which omits the most volatile components) reaching an 30-year high of 3.7% (Chart 9). The rise in inflation has been broad-based, with large increases seen for both goods inflation (6.8%) and services inflation (3.7%). Like the US, high inflation is becoming more embedded in survey-based inflation expectations. Canadian businesses expect inflation to be 3.2% over the next two years, according to the Business Outlook Survey.1 Canadian consumers expect inflation to be 4.9% over the next year and 3.5% over the next five years, according to the BoC’s Canadian Survey Of Consumer Expectations (Chart 10). The latter had been very stable around 3% since the survey began back in 2014, thus the 0.5 percentage point jump seen in the latest quarterly survey is a highly significant move that suggests the 2021 inflation surge is become more embedded in Canadian consumer psychology. Chart 9The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands ​​​​​​ Chart 10Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising ​​​​​​ The Canadian inflation backdrop has similarities to the US situation described earlier in this report. Like the US, one-year-ahead Canadian consumer inflation expectations are far above wage expectations (only +2%), which suggests that Canadian consumers expect real wages to contract -2.9%. Also like the US, falling real wage expectations are acting as a drag on Canadian consumer confidence (bottom panel). And also like the US, we expect Canadian workers to increase their wage demands to restore real purchasing power, potentially starting a wage-price spiral. Given widespread Canadian labor market shortages, this process has likely already started. According to the BoC Business Outlook Survey, 43% of firms had to boost wages in Q4/2021 because of “cost of living adjustments”, compared to 29% in Q3/2021 (Chart 11). An even larger share of respondents in the Q4 survey (54%) reported having to raise wages to attract and retain workers, up significantly from Q3 and an indication of how Canadian firms are seeing their wage bill go up trying to find quality labor in a tight job market. Chart 11 Given the messages on growth and inflation from its surveys, the BoC has all the evidence it needs to begin the rate hiking process as soon as possible. The bigger question is how high will rates have to go to cool off Canadian economic growth and bring inflation back into the BoC’s 1-3% target range. The BoC’s own internal models estimate that the neutral level of the policy interest rate is between 1.75% and 2.75%. Those estimates were last produced back in April 2021, however, and the range may need to be revised higher to reflect the changes seen in the Canadian economy since then – most notably the greater supply constraints and higher inflation. At a minimum, the BoC will likely have to raise the policy rate to the higher end of its last estimated range for the neutral rate. Current market pricing in the Canadian OIS curve discounts the BoC hiking the policy rate from 0.25% today to 1.6% by the end of 2022 (Chart 12). With eight scheduled BoC policy meetings this year, including this week, the 2022 pricing is realistically achievable. However, only another 50bps of hikes are priced for 2023 and no additional hikes after that. Chart 12Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Chart 13Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds A peak policy rate around 2% would only be in the lower half of the BoC’s range of neutral rate estimates. It would also represent a very low peak real rate of 0% assuming inflation returns to the midpoint of the BoC target range. It is possible that markets are underestimating how high the BoC will have to lift rates, both in nominal and real terms, because of a fear that rate increases will hurt highly indebted Canadian homeowners and trigger a sharp pullback in house prices. This is a legitimate concern given the stretched housing valuations across most major Canadian cities. However, the BoC is facing the same credibility issue that the Fed and other inflation-targeting central banks are facing in the pandemic era. Canadian inflation is too high and becoming more embedded in inflation expectations. Also like the Fed, the BoC will have to fight the inflation battle now and deal with the collateral damage on financial conditions (and the housing market) later. Importantly, with the Fed also likely to deliver several rate hike in 2022. Thus, the BoC has less need to fear a surge in the Canadian dollar, driven by widening interest rate differentials, that could aggressively tighten financial conditions beyond the impact on asset markets and house prices from higher interest rates (Chart 13). Summing it all up, we maintain our negative strategic outlook on Canadian government bonds as markets are underestimating the tightening that will be required from the BoC over the next 1-2 years. Bottom Line: The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with medium-term consumer inflation expectations now above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Business inflation expectations calculated as the share of respondents reporting expected inflation within a certain range multiplied by the midpoint of the range. We assume a value of 0.5 for “less than 1” and a value of 3.5 for “greater than 3”. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights Banks, households, and businesses are still swimming in cash: Asset purchases and zero rates are ending, but banks, households and businesses have more cash than they know what to do with. It will not be easy for the Fed to mop up enough accommodation to slow the economy in a material way this year. The flood of liquidity may be a headwind for interest rates in 2022, … : The biggest banks have positioned themselves to benefit from rising rates and may limit the backup in yields as they deploy their unused capital hoard into it.  … and protect equities from suffering meaningful de-rating: All the money has to go somewhere, and equities may be the default winner if bonds and cash are poised to deliver negative real returns. The rosy near-term outlook implied by the biggest banks’ observations suggests that the bull market in risk assets isn’t over yet: Households have ramped up spending but have barely begun to tap into their excess savings and businesses are confident and well-heeled. Above-trend economic growth should bolster corporate earnings, credit performance and financial asset prices, keeping the bull market going through the end of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing the Martin Luther King long weekend. Their performance wasn’t bad – the SIFIs squarely beat analysts’ consensus estimates and USB came up about 3% short – but investors apparently wanted more from a group that had burst out of the gate to start 2022. Banks were market darlings in the year’s first nine sessions as investors sought out stocks that could outperform in a rising rate environment, and the SIFIs and USB beat the S&P 500 by 12 percentage points (Chart 1). Over the three sessions that they reported earnings, they gave back more than a third of their relative outperformance, though they still have a 7-point year-to-date advantage. Chart 1Rate Play Rate Play Rate Play Our focus, however, is not on the banks themselves or their stocks’ relative performance. We’re after what the principal financial intermediaries are seeing from their privileged vantage point into activity across the economy. We examine the banks’ earnings releases and listen to their earnings calls for insight into the broad macro backdrop as revealed by borrower performance, lender willingness, the state of the financial system and the actions and intentions of households and businesses. Considering the banks’ calls from that perspective, several growth-friendly themes emerged. Households remain flush with cash, even at the lower end of the wealth distribution, heralding robust 2022 consumption. Deposits from households and businesses continue to pile up, supporting credit performance and likely pushing out the date when net charge-off rates will rise to more normalized levels. The deposit flows are increasing the banks’ capacity to lend, and they are champing at the bit to deploy their cash into new loans. Investment banking pipelines are full and rampant liquidity should see to it that new debt and equity offerings meet with a warm reception once they come to market, as long as the current bout of market turbulence doesn’t lead to a lasting rollback in animal spirits. All in all, the banks’ observations affirmed our constructive take on the economy through at least the end of the year. Households are already spending in a way that validates our time-release view of fiscal transfers and their incomes have apparently risen enough that they have not yet begun to deplete the savings they built up from Congress’ pandemic largess. Businesses remain flush and are looking to replenish depleted inventories to reduce their vulnerability to supply chain disruptions. M&A activity is still hot and underwriting calendars are full. Yields are poised to rise as the Fed dials down monetary accommodation, but it’s possible the banks’ eagerness to put their idle cash to work will help limit how high they can go. Households Have Been Spending (Chart 2), But They Still Have Loads Of Dry Powder (Chart 3) … [F]or the holiday period of November and December, [debit and credit] spending was up 26% over 2019. … And so far this year that strength continues. [S]pending of all types through January 17 … [was] up over 11% versus the start of ’21, which is well up over ’20 and ’19, and that bodes well for the rest of the year and quarter. (Moynihan, BAC CEO) Chart 2You Can't Keep An Avid Consumer Down You Can't Keep An Avid Consumer Down You Can't Keep An Avid Consumer Down Chart 32 Trillion Of Excess Savings ... 2 Trillion Of Excess Savings ... 2 Trillion Of Excess Savings ... [C]ombined credit and debit [card] spend was up 27% versus the fourth quarter of 2019, with each quarter in 2021 showing sequential growth compared to 2019. Within that, travel and entertainment spend was up 13% versus 4Q19, though we have seen some softening in recent weeks contemporaneously with the Omicron wave. (Barnum, JPM CFO) Consumer credit card spend also continued to be strong, up 28% from the fourth quarter of 2020 and up 27% from the fourth quarter of 2019. All spending categories were up in the fourth quarter compared to a year ago, with the largest increases in travel, fuel, entertainment and dining. (Scharf, WFC CEO) [W]hile there is some softening [from Omicron] in restaurant, travel and entertainment in recent weeks, overall spending remained strong in the first week of January with credit card up 26% and debit card up 29% versus the same week in 2020. (Scharf, WFC) [W]e are seeing increases in [card] spend volume … across the board, [with] branded card spend volumes up 24% and retail services spend volumes up 16%[.] People are using our cards, which is a good thing. (Mason, C CFO) [C]onsumer[s] [are] in really good shape, … spending … 25% more than they spent pre-COVID, 25% more. And that number drives all the order books for everybody else. (Dimon, JPM CEO) We believe there’s lots of potential spending capacity left as average deposit balances (Chart 4) continue to move up … despite … heavy spending[.] We had [only] one cohort of deposits that dipped [in any] month [in] the last part of the year: … customers who had balances of $2,000 or less pre-pandemic [saw their balances] dip by 1% [in November]. Other than that, every cohort from June [through] December [had their balances] grow every month. And what’s striking is that the balances for people who had less than $2,000 average balances before the pandemic [now have] five times [their pre-pandemic] balances. [C]ustomers who had $10,000 in their accounts before the pandemic are now sitting with two times [that] in their accounts. (Moynihan, BAC) Chart 4... Are Sitting In Checking Accounts, Waiting To Be Spent ... Are Sitting In Checking Accounts, Waiting To Be Spent ... Are Sitting In Checking Accounts, Waiting To Be Spent Chart 5  … Helping Credit Performance (Chart 5) And Keeping A Lid On Card Balances (Chart 6) Chart 6Cash-Rich Consumers Don't Need To Carry Credit Card Balances Cash-Rich Consumers Don't Need To Carry Credit Card Balances Cash-Rich Consumers Don't Need To Carry Credit Card Balances The asset quality of our customers remains very healthy and net charge-offs this quarter fell to a historical low of … 15 basis points of average loans. … Our credit card loss rate was 1.42%, … less than half of the pre-pandemic rate, [and] it improved in every quarter during the year. (Borthwick, BAC CFO) [O]ur 30, … 60 or 90 days past [due consumer loans] are staying at … low levels. … [C]ustomer [checking account] balances, elevated in some cases five times [above] … pre-pandemic levels … probably account for a lot of the consumer credit quality improvement. We’re anticipating at some point it will go back towards more normal historical levels. We just think it’s going to bump around here for a little while. (Borthwick, BAC) [W]e’re exiting the fourth quarter with a card net charge-off rate of … something like 1.2% -- -- Which you’ll never see again (Barnum and Dimon, JPM) [C]redit card [charge-offs] has been a number that we’ve never seen in our lives. Middle market has been lower than ever. … Mortgages have been lower than ever. They’re all low. Eventually, they’re going to normalize. (Dimon, JPM) In terms of [card] losses, … [we are seeing] very low loss levels. [W]hen I look at the delinquency trend, there’s really nothing to focus on there. [Delinquencies] remain quite low and we don’t see any signs or areas of concern. (Mason, C) Payment rates do remain stubbornly high, [negatively] impacting our loan growth … in [our] cards businesses. (Mason, C) Consumer credit performance remains strong with higher collateral values for homes and autos and consumer cash reserves remain[ing] above pre-pandemic levels. (Santomassimo, WFC CFO) Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio to remain lower than historical levels, but normalize over time as the effects of the pandemic continue to subside. (Dolan, USB CFO) Business Borrowing May Be Turning A Corner (Chart 7) Chart 7Are Middle-Market Corporate Borrowers Really Back? Are Middle-Market Corporate Borrowers Really Back? Are Middle-Market Corporate Borrowers Really Back? [Sequential] growth was broad-based across all commercial lending segments. We saw improvement in new loans as well as improvement in utilization from existing clients. … In the all-important small business segment, lending activity is running consistently above pre-pandemic levels. (Moynihan, BAC) We are seeing an uptick in revolver utilization rates, … and it remains sort of skewed to the smaller clients. But we are starting to see an uptick … even in the bigger clients. … [O]ne driver of that is CEOs and management teams have been burned by low inventory levels as a result of the supply chain problems, wanting to run higher inventories and that is maybe driving higher utilization. … At the same time, we’re hearing quite a bit of confidence in the C suites, and all else equal that should be positive for C[ommercial]&I[ndustrial] loan growth. The levels there are modest still in a world where capital markets have been exceptionally receptive to … [bond] issuance … and so people [have been] well-funded [by the] capital markets. (Barnum, JPM) Commercial loan balances started to increase late in the third quarter and have now grown for four consecutive months with growth accelerating in December. … Increases in middle-market banking were driven by growth from our larger clients, a modest uptick in revolver utilization and strong seasonal borrowing. Growth in asset-based lending and leasing was driven by new client wins as well as increased levels from higher prices and some increase in inventory levels. (Santomassimo, WFC) We are encouraged by the loan growth momentum and we have a positive outlook for 2022, given improving client sentiment and business conditions, and continued strength in certain focused commercial portfolios, such as asset-backed securitization lending and supply chain financing. (Cecere, USB CEO) [W]e’re now starting to see a nice shift with respect to the commercial and the C&I portfolios. … At the end of the fourth quarter, we saw nice expansion of utilization rates, … like 60 basis points on average from the third quarter, but in December it was up almost 2.5%. … [P]eople are rebuilding their inventories on the commercial side. I think … they still have some [supply chain] concerns, so I think they’re being cautious about making sure they have inventory to be able to run their business. And I think they’re starting to make business investment ahead of the consumer spend and the economic growth they see in 2022. (Dolan, USB) [The] number one fourth-quarter trend that looks positive going into 2022 is the increase in utilization rates, which we haven’t seen for a number of quarters. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 8) And Want To Put It To Work (Chart 9) When The Time Is Right Chart 8Water, Water Everywhere And Not A Drop To Drink Water, Water Everywhere And Not A Drop To Drink Water, Water Everywhere And Not A Drop To Drink Chart 9Banks Are Eager To Lend Banks Are Eager To Lend Banks Are Eager To Lend Given continued deposit growth and low rates, our asset sensitivity to rising rates remains significant. (Borthwick, BAC) [W]e still have significant dry powder to put to work with either client demand [loans] or in an increasing rate environment [securities], which we expect. (Mason, C) [W]e have huge firepower to grow, to expand, to make loans, to extend duration. I’ve never seen a bank with [our level of] liquidity: $1.7 trillion in cash and marketable securities and $1 trillion in loans. There’s $500 or 600 billion of those cash and marketable securities that could be deployed in higher-yielding assets or loans when and if the time comes. (Dimon, JPM) [Our] expectation is that when long-term rates rise, which we’re starting to see now, we’re going to be able to take advantage of the rising rate environment. … We [deployed some cash into securities] in the fourth quarter but employed hedging strategies to keep the duration of those purchases relatively short … to maintain as much asset sensitivity going into 2022 as we possibly could. (Dolan, USB) [W]e want maximum flexibility as long-term rates start to rise. (Dolan, USB) Investment Implications​​​​​​​ Chart 10Comeback Or Head Fake? Comeback Or Head Fake? Comeback Or Head Fake? The biggest banks told a consistent story about the US economy on their earnings calls. Activity is rising, as evidenced by avid consumption that gathered momentum across 2021, a pickup in business and consumer appetite for borrowing that quickened toward the end of the year (Chart 10), and expressions of confidence from businesses that are directing capital to replenishing inventories and buying equipment. Credit performance is tremendously strong with record-low net charge-off rates and low delinquency rates underpinned by bloated business and consumer deposit balances. Abundant cash reserves provide further fuel for consumption and should keep GDP growth well above its trend level. The growth and credit tailwinds suggest that a recession is not lurking around the corner and therefore offer a green light for investors to overweight equities within multi-asset portfolios. As detailed in the last two reports on rate hikes’ impact, we do not view the recent equity turbulence, triggered by a surge in Treasury yields, as the start of an inflection point for financial markets. We are inclined to see the decline as more of a buying opportunity than a herald of a new shift in the business cycle. The Fed has the means to slow the economy if it sets its mind to it but given the amount of cash that is overwhelming banks, businesses, households and investors, draining enough accommodation to do so by the end of 2022 is an awfully tall order.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

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

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

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 ​​​​​ Chart 2Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth ​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 ​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence ​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way ​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years 2022 Key Views: The Story Gets More Complicated 2022 Key Views: The Story Gets More Complicated The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns ​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure ​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure ​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 ​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure ​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations ​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. Chart 19 With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability ​​​​​​ Chart 22 In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom ​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom ​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling ​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched ​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 ​​​​​​ Chart 29 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 30 Chart 31Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? Will Services Spending Recover To Its Pre-Pandemic Trend? Will Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1.  How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 The Pandemic's Sine-Wave Will Propagate Into 2022 The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2.    Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Dental Services Are Far Below The Pre-Pandemic Trend Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend Physician Services Are Far Below The Pre-Pandemic Trend Physician Services Are Far Below The Pre-Pandemic Trend   Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Recreation Services Are Far Below The Pre-Pandemic Trend Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Public Transportation Is Far Below The Pre-Pandemic Trend Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-7). Image The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4.    How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Goods Prices Have Reacted To A Positive Demand Shock... Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock ...But Service Prices Have Not Reacted To A Negative Demand Shock ...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive.  This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5.    Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value Cryptocurrencies Will Continue To Displace Gold's Investment Value Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6.    How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Chart I-11 Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7.    Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Chart I-12 Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation Property Price Inflation Has Far Exceeded Rent Inflation Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits The US Stock Market = The 30-Year T-Bond Multiplied By Profits The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Underweight Commodities That Haven't Yet Corrected Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services Underweight Personal Goods Versus Consumer Services Underweight Personal Goods Versus Consumer Services   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Dear Client, The next two BCA Research Global Fixed Income Strategy reports will be jointly published with other BCA services, which will impact the publishing dates. Our next report will be a joint Special Report on Australia, published with our colleagues at Foreign Exchange Strategy, which you will receive this Friday, November 19. The following report will be a joint Special Report published with European Investment Strategy, which you will receive on November 29. -Rob Robis   Highlights High realized inflation rates are pushing up longer-term inflation expectations toward all-time highs, while also weighing on consumer confidence, in the US and the UK. The inflation overshoot has not been as severe in the euro area, but consumer confidence appears to be rolling over there too. Over the next year, central banks will have to manage around the communications challenges posed by a rise in inflation that is perceived to be more supply-driven than demand-driven and, hence, beyond the full control of monetary policy. Public opinion surveys are showing eroding satisfaction with the Fed and Bank of England, while similar surveys in the euro area show public trust in the ECB remains strong despite higher euro area inflation.  We continue to favor overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23, compared to the euro area, in order to restore central bank credibility.  Feature Rapidly accelerating inflation has become front-page news around the world. It is also increasingly becoming a political issue and not just an economic one. After the release of the October US consumer price index (CPI) report, where headline inflation came in at a 30-year high of 6.2%, US President Joe Biden had to issue a formal White House statement acknowledging that inflation “hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” Biden also pulled off the neat trick of both committing to, and subtly challenging, the Fed’s independence when he noted that “I want to reemphasize my commitment to the independence of the Federal Reserve to monitor inflation, and take necessary steps to combat it.” The Great Inflation Of 2021 (and 2022?) has raised a new risk for both politicians and investors. As long as the high inflation persists, and for as long as central banks seem unwilling or unable to respond to try and bring down inflation with tighter monetary policy, consumer confidence will be negatively impacted – even if job growth remains reasonably healthy. Confidence & Inflation: A Matter Of Trust Chart of the WeekHigh Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence The preliminary read on US consumer confidence for November from the University of Michigan survey showed sentiment hitting a ten-year low, largely on worries about the impact of rising inflation on household spending power. This effect of high inflation eroding consumer confidence is not just a US phenomenon (Chart of the Week). UK consumer sentiment is also falling due to what has been described as “a potential cost of living crisis” by consumer research firm GfK. In the euro area, however, consumer sentiment is still relatively elevated, but is starting to roll over as headline inflation reaches a 13-year high of 4.1% in October. From the point of view of financial markets,  surging inflation is still expected to be a short-lived phenomenon, although conviction on that view is starting to wane. Market-based inflation expectations curves for the US, UK and euro area are all currently inverted, with shorter-maturity expectations above longer-maturity ones (Chart 2). Yet the upward momentum of those measures across all maturity points is showing little sign of ebbing, especially in the US. The 2-year TIPS breakeven rate now sits at a 16-year high of 3.51%, the 5-year breakeven is at an all-time high of 3.22%, while the 10-year breakeven of 2.77% is now just a single basis point below its all-time high reached in 2005. The story is similar in the UK, where RPI swap rates for the 2-year, 5-year and 10-year maturities are 5.3%, 4.8% and 4.3%, respectively – all hovering near all-time highs (as are breakevens on index-linked Gilts). Euro area inflation expectations are not so historically elevated, and the inflation curve is not as inverted, but the 2-year euro CPI swap rate is still at a 15-year high of 2.4% compared to a 9-year high of 2.0% - right at the ECB’s inflation target - for the 10-year CPI swap rate. In the US, the survey-based measures of inflation expectations are telling a similar story. The New York Fed’s Consumer Survey shows that median 3-year expectations are now at 4.2% with 1-year expectations even higher at 5.7% (Chart 3). Meanwhile, the early November read on inflation expectations from the University of Michigan survey showed that 1-year-ahead expectations climbed to a 13-year high of 4.9%, while the longer-term 5-10 year inflation expectations were unchanged from the October reading of 2.9%. Chart 2Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Chart 3A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation The latter figure may provide some comfort to the Fed, with surging shorter-term expectations not fully leaking through into longer-term expectations. However, the longer the inflation upturn persists, the more likely it will be that US consumers begin to factor in a higher rate of longer-term inflation, just as TIPS traders are doing. After all, the Michigan 5-10 year measure has still climbed by 0.7 percentage points from the pre-COVID low. Even more worrying from the Fed’s perspective is that inflation expectations are rising for essentially all Americans. The New York Fed Consumer Survey shows that 3-year-ahead inflation expectations are rising across all levels of education (Chart 4) and income cohorts (Chart 5). Chart 4US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... Chart 5...And Income Levels ...And Income Levels ...And Income Levels The New York Fed also compiles a measure of consumer inflation uncertainty (bottom panels of both charts on page 5). Survey participants are asked to provide probabilities of inflation falling within certain ranges, with the gap between the top and bottom quartiles of those expected inflation outcomes representing the “uncertainty” over future US inflation. Perhaps unsurprisingly, the dispersion of inflation forecasts is typically much wider for those earning lower incomes and with less education. Yet even highly educated, high earning Americans are reporting wider gaps in possible inflation outcomes, in sharp contrast to the pre-COVID years where their expectations were low and stable. Americans Are Having Second Thoughts About The Fed Any way you cut it – TIPS breakevens or survey-based measures - US inflation uncertainty and volatility have increased. This appears to be starting to erode public confidence with the Fed. Along with its consumer confidence surveys, the University of Michigan also publishes a periodic survey of Confidence In Financial Institutions like commercial banks, asset managers and, most importantly, the Fed. The last survey was just conducted for the September/October 2021 period and showed that 43% of respondents reported a loss of confidence in the Fed compared to five years ago (Chart 6). That is up from 36% reporting a loss of confidence in the last such survey conducted in 2019, and is approaching the +50% levels seen in 2008 (the Financial Crisis) and in 2011 (the Taper Tantrum) – episodes where the Fed had difficulty maintaining economic and financial stability. Chart 6 The University of Michigan also noted that reported consumer confidence was much lower for those claiming to have less confidence in the Fed, and vice versa (Chart 7). Chart 7 Taken at face value, this survey shows that the Great Inflation of 2021 has shaken the public’s faith in the Fed’s ability to maintain economic stability. Combined with the message from the New York Fed Consumer Survey on the growing instability of American inflation expectations, this shows that the Fed may be facing an uphill climb to restore some of the credibility it has lost this year. Much like all aspects of American life these days, political partisanship must be factored in the analysis of US confidence data. The regular monthly University of Michigan sentiment survey for November noted that various measures of US confidence were consistently higher for respondents who reported to be Democrats compared to Republicans since President Biden took office (Chart 8). This is a mirror image of the years under President Trump (pre-pandemic), where Republicans consistently reported greater optimism than Democrats. Chart 8 Chart 9Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad The University of Michigan Confidence in Financial Institutions survey also noted that less trust in the Fed was reported more frequently by Republicans (67%) than Democrats (27%) in 2021, the first year under Biden. This compares to 2017, the first year of the Trump Administration, where more Democrats (41%) reported less trust with the Fed compared to Republicans (30%). The Michigan survey described this “partisan identification” as being a “significant correlate of consumer assessments of the Federal Reserve, treating the Fed as part of the administration rather than an independent body.” Consumer confidence among reported Democrats has been falling since April of this year, although there is still room to catch up to the complete collapse of sentiment seen among Republican consumers (Chart 9, top panel). High US inflation is hitting everyone hard. The surge in inflation expectations is overwhelming income expectations for the next year, according to the New York Fed Consumer Survey (middle panel). High realized inflation has also eroded real spending power, with real average hourly earnings having contracted in year-over-year terms since April of this year (bottom panel). Even with that fall in real income growth perceptions, the plunge in the University of Michigan US consumer confidence has not been matched by other measures like the Conference Board US consumer confidence index, which remains well above pandemic era lows. Even more importantly, US consumer spending has held up well, with nominal retail sales expanding by +1.7% in October following a +0.8% gain in September. Some of those increases were due to rising prices, but were still significantly above inflation in both months, suggesting a solid pace of real consumer spending (the headline US CPI index rose +0.9% and +0.4% in October and September, respectively). For the Fed, the case is building to begin preparing Americans for higher interest rates in 2022. This is true both from an economic perspective – the US economy is likely to continue growing above trend next year, further tightening the US labor market – and in response to the high inflation that has caused some damage to the Fed’s credibility. What About The UK And Euro Area? Looking across the Atlantic, survey-based measures of inflation expectations have also climbed steadily higher (Chart 10). The YouGov/Citigroup survey of UK consumer inflation expectations is now at 4.4% for the 1-year-ahead measure and 3.7% for the longer-run 5-10 year ahead measure, both well above the BoE’s 2% inflation target. The European Commission surveys show a rapidly rising share of European Union businesses and consumers expect higher prices in the coming months. Yet while inflation expectations are rising in both the UK and Europe, only the UK shows the sort of deterioration in central bank confidence that is evident in the US. 48% of Europeans expressed confidence in the ECB, according to the Eurobarometer public opinion surveys – the highest share since 2007 and well above the 36% level seen after the Global Financial Crisis and European Debt Crisis (Chart 11). Some of that improvement in perceptions of the ECB mirrors better sentiment over the euro currency itself, as evidenced by that fact that both Germans and Italians now express similar levels of ECB confidence. Chart 10High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US Chart 11Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB High levels of public trust in the ECB play an important role in anchoring European inflation expectations. The ECB introduced its own Consumer Expectations Survey as a pilot project last year, and the latest reading from October 2021 shows that 1-year-ahead inflation expectations are now at 3% and 3-year-ahead expectations are at 2%. Both measures were at 2% a year earlier, and have generally stayed close to ECB’s 2% inflation target since the survey began. Chart 12High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE A recent research report from the Bank of Finland concluded that European consumers who have high trust in the ECB adjust their medium-term inflation expectations more slowly than those with low trust. The high public confidence in the ECB seen in the Eurobarometer surveys, combined with the stability of medium-term inflation expectations (both survey-based and market-based) around the ECB’s 2% target – even with realized euro area inflation now at 3.4% - fits with the conclusions of that report. We read this as a sign that the ECB is not under the same growing pressure to tighten policy in the face of rising inflation as the Fed, which is facing an erosion of public confidence that is showing up in steadily rising inflation expectations. In the UK, the Bank of England (BoE) is facing a situation more akin to that of the Fed. The BoE’s Inflation Attitudes Survey has been showing a steady erosion of UK consumers reporting satisfaction with how the BoE has been setting policy to fight inflation (Chart 12). The “net satisfied” index fell to +18% in the last survey published in September – similarly low levels of BoE satisfaction coincided with major spikes in longer-term UK inflation expectations in 2008 and 2011 (bottom panel). Our conclusion from the UK consumer surveys, along with measures of inflation expectations that are well above the BoE medium-term target, is similar to that in the US. The UK public is losing faith in the BoE’s ability, or willingness, to tackle the high inflation “problem” – even if much of the inflation is caused by high energy prices and global supply chain disruptions that are beyond the immediate control of monetary policy. The BoE will likely need to follow through on the rate hikes markets expect in 2022 to help restore public trust and credibility, even if realized inflation slows from current elevated levels. This is especially true after the debacle of the November 4 BoE meeting where a widely-signaled rate hike did not occur. If the BoE continues to delay the start of tightening while inflation expectations are accelerating, this will only put more pressure on the central bank to tighten faster, and by more than expected, in a bid to stabilize inflation expectations. Investment Conclusions Chart 13Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Our read of the various surveys shows that public trust in central banks has deteriorated in the US and UK, but not in Europe, because of surging inflation in 2021. This compounds the existing trends of tightening labor markets and accelerating wage growth in the US and UK that are more traditional reasons to tighten monetary policy. We continue to favor strategic overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23 in order to restore public trust in the Fed and BoE (Chart 13). The ECB can continue to be patient on responding to higher euro area inflation, given more stable euro area inflation expectations and with limited evidence that higher realized inflation is boosting European wage growth. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index