Consumer Discretionary

Highlights Demand in the major economies remains well below its pre-pandemic trend. Meaning that relative to potential output, demand is lukewarm, at best. Inflation is hot, not because of strong overall demand, but because of the surging demand for goods. If the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Underweight personal goods versus consumer services. Bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market and the $100 trillion global equity market. Long-term investors should continue to own US T-bonds and focus their equity investments in long-duration (growth) stocks, sectors, and stock markets… …because the ultimate low in bond yields is yet to come. Feature Chart of the WeekWill Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? 2022 begins with an investment conundrum. Why have long bond yields been so chilled when inflation is running so hot? (Chart I-1) While US and UK inflation have ripped to 6.9 percent and 5.1 percent respectively, the 30-year T-bond yield and 30-year gilt yield remain a relative oasis of calm – standing at 2.1 percent and 1.2 percent respectively. 10-year yields have also stayed relatively calm. Moreover, as long-duration bonds set the valuations of long-duration stocks, a calm bond market has meant a calm stock market. What can explain this apparent conundrum of chilled yields in the face of the hottest inflation in a generation? Long Bond Yields Are Tracking Demand, Not Inflation Chart I-2 answers the conundrum. The long bond yield is taking its cue not from hot inflation, but from economic demand, which is far from overheating. Quite the contrary, US real GDP and consumption are struggling to reach their pre-pandemic trends. Meanwhile, UK real GDP languishes 5 percent below its pre-pandemic trend (Chart I-3), and other major economies tell similar stories. Chart I-2Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Chart I-3Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Some people mistake the strong economic growth in recent quarters for overheating demand. In fact, this robust growth is just the natural snap-back after the pandemic induced collapse in early-2020. Meaning that the strong growth is unsustainable, just as the bounce that a ball experiences after a big drop is unsustainable. Demand in the major economies remains well below its pre-pandemic trend. To repeat, demand in the major economies remains well below its pre-pandemic trend. As this pre-pandemic trend is a good gauge of potential output, economic demand is lukewarm, at best. And this explains why long bond yields have remained chilled. Inflation Is Tracking The Displacement Of Demand Yet solving the first conundrum simply raises a second conundrum. If overall demand is lukewarm, then why is inflation so hot? (Chart I-4). The answer is that inflation is being fuelled by the displacement of demand into goods from services (Chart I-5). Chart I-4Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Chart I-5Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods If a dollar spent on goods is displaced from a dollar spent on services, then overall demand will be unchanged. However, what happens to the overall price level depends on the relative price elasticities of demand for goods and services. If the price elasticities are the same, then overall prices will also be unchanged, because a higher price for goods will be exactly countered by a lower price for services. But if the price elasticities are very different, then overall prices can rise sharply because the higher price for goods will dominate overall inflation. All of which solves our second conundrum. Spending on services that require close contact with strangers – using public transport, going to the dentist, cinema, or recreational activities that involve crowds – are suffering severe shortfalls compared to pre-pandemic times. Some people say that this is due to supply shortages, yet the trains and buses are running empty and there is no shortage of dentists, cinema seats, or even (English) Premier League tickets. Indeed, the Premier League team that I support (which I will not name) has been sending me begging emails to attend matches! Surging inflation is no longer a reliable reflection of overall demand. If somebody doesn’t use public transport, or go to the cinema or crowded events because he is worried about the health risk, 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 other words, the price elasticity of demand for certain services has flipped from its usual negative to zero, or even positive.   This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging inflation is no longer a reliable reflection of overall demand, which remains below its potential. Instead, surging inflation is largely reflecting the surging demand for goods. Two Ways That Inflation Can Resolve: One Good, One Bad It follows that if the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. 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. We recommend that equity investors play this inevitable normalisation by underweighting personal goods versus consumer services. Still, the resolution of inflation could also take a ‘bad’ form. If inflation persisted, then bond yields could lose their chill as they flipped their focus from lukewarm demand to hot inflation. Given that long-duration bonds set the valuations of long-duration stocks, and given that stock valuations are already stretched versus bonds, this would quickly inflict pain on stock investors (Chart I-6). Chart I-6The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits More significantly, it would also quickly inflict pain on the all-important real estate market. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent1 (Chart I-7). 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 (Chart I-8). Chart I-7The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion… The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... Chart I-8…And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields This means that bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, the massive deflationary backlash would annihilate any lingering inflation. Some people counter that in an inflationary shock, stocks and property – as the ultimate real assets – ought to perform well even as bond yields rise. However, when valuations start off stretched as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. The scope for higher bond yields is limited by the fragility of stock market and real estate valuations. With the scope for higher yields limited by the fragility of stock market and real estate valuations, and with the ultimate low in yields yet to come, long-term investors should continue to own US T-bonds. And they should focus their equity investments in long-duration (growth) stocks, sectors, and stock markets. Fractal Trading Update Owing to the holidays, we are waiting until next week to initiate new trades. We will also add a new feature – a ‘watch list’ of investments that are approaching potential turning points, but are not yet at peak fragility. We believe that this enhancement will help to prepare future trades. Stay tuned.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 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 Image 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 - 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 - 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 Long-only investors with a minimum horizon of two years should buy the interactive entertainment sector. Hedge fund investors with a minimum horizon of two years should go long interactive entertainment versus technology. Despite a trebling of sales since 2014, interactive entertainment comprises just 0.2 percent of world GDP, and just 0.3 percent of US consumer spending, providing scope for substantial further growth. Looking ahead, we identify four specific drivers of growth: cloud gaming, e-sports, 5G, and ‘gaming as a service’. After this year’s sell-off, the sector’s relative valuation has fallen below its long-term average. Even more striking, the sector now trades at a record 20 percent discount to the tech sector. Yet we think we can do better than the sector index and reveal our preferred basket of interactive entertainment stocks. Feature In the future, a typical day will be divided into three. A third we will spend sleeping and dreaming; a third we will spend in reality; and a third we will spend in virtual reality. Parents of teenagers may already recognise this pattern, and will certainly do so over the coming holiday season! But many people in their twenties and thirties are also spending more of their time in the virtual world entered through the portal of interactive entertainment (meaning video gaming, and we will use these terms interchangeably throughout this report). Since 2014, interactive entertainment has experienced explosive growth. Since 2014, interactive entertainment has experienced explosive growth. Sales have trebled, outperforming even the tech sector whose sales have doubled, and far outperforming the total stock market’s sales (and global GDP) which are up a sedate 30 percent (Chart I-1 and Chart I-2). Yet despite this explosive growth, interactive entertainment comprises just 0.2 percent of world GDP, and just 0.3 percent of US consumer spending, providing scope for substantial further growth (Chart I-3 and Chart I-4). Chart I-1Since 2014, Interactive Entertainment’s Sales Have Almost Trebled… Since 2014, Interactive Entertainment's Sales Have Trebled... Since 2014, Interactive Entertainment's Sales Have Trebled... Chart I-2…And Its Profits Have More Than ##br##Trebled ...And Its Profits Have Quadrupled ...And Its Profits Have Quadrupled Chart I-3 Chart I-4…And 0.3 Percent Of US Consumer Spending ...And 0.3 Percent Of US Consumer Spending ...And 0.3 Percent Of US Consumer Spending Meanwhile, the interactive entertainment sector’s profit margin has also trended higher, to 14 percent. This compares with 16 percent for tech, and around 10 percent for the total stock market (Chart I-5). Chart I-5Interactive Entertainment’s Profit Margin Has Trended Higher Interactive Entertainment's Profit Margin Has Trended Higher Interactive Entertainment's Profit Margin Has Trended Higher The combination of explosive sales growth and higher margins has resulted in spectacular profit growth. Interactive entertainment profits have skyrocketed by 250 percent, outperforming tech profits which are up 150 percent, and far outperforming total stock market profits which are up 50 percent. We expect this strong outperformance in profits to continue. Cloud Gaming, E-Sports, 5G, And ‘Gaming As A Service’ Will Drive Sales Growth Looking ahead, we identify four specific drivers of growth: cloud gaming, e-sports, 5G, and ‘gaming as a service’. Cloud gaming (gaming-on-demand) streams high quality interactive content that is running on remote servers, akin to how remote desktops work. Thereby, gamers can play using just a device and an internet connection. Cloud gaming displaces physical disks, powerful hardware, and the need to download games onto a platform – analogous to how the on-demand streaming of media and entertainment has displaced DVDs and cable TV. Cloud gaming benefits both content developers and players. Developers do not have to worry about piracy, illegal downloads or digital rights management. Players benefit from a high (and equal) server processing power, creating a level-playing field in games. Which brings us nicely to the second driver of growth: e-sports. E-sports refers to competitive video gaming, a sector which is experiencing massive growth. 175 colleges and universities have already become members of the National Association of Collegiate Esports (NACE), offering varsity e-sports programs, and recognizing student gamers through scholarship awards. E-sports are hugely popular not only for their competitive element but also for their opportunity for social engagement, albeit virtually. The third major driver of interactive entertainment profits is the widespread rollout of 5G cellular networks, which makes cloud gaming accessible to mobile devices, rather than just to consoles and PCs. Mobile gaming revenues have become the most powerful engine of growth. This is significant because revenues from mobile gaming have now overtaken the combined revenues from the console and PC platforms. As such, mobile gaming revenues have become the most powerful engine of growth (Chart I-6 and Chart I-7). Chart I-6 Chart I-7 The fourth driver of profits is the ‘gaming as a service’ (GaaS) revenue model, which is analogous to the software industry’s standard ‘software as a service’ (SaaS) revenue model. Instead of a one-time sale, revenue comes from a continuous stream of in-game sales and subscriptions. For example, Activision Blizzard’s doubling of revenues since 2014 has come mostly from in-game subscriptions. Product sales now comprise less than 30 percent of total revenues (Chart I-8). Chart I-8 As well as being a major contributor to strong sales growth, GaaS boosts profit margins by lengthening the sales derived from the fixed costs of developing a given game.  But Isn’t Video Gaming An Unhealthy Addiction? In 2018, the World Health Organization recognized 'gaming disorder' as an addictive behaviour and has officially defined it in the 11th Revision of the International Classification of Diseases (ICD-11). Then in August this year, the Chinese government imposed harsh restrictions on video gaming for minors. Under-18s can play video games for a maximum of three hours a week, one hour each on Friday, Saturday, and Sunday. These developments beg the question, is the interactive entertainment sector exposed to significant regulatory risks? The crackdown and regulation of illicit activities should be welcomed, not feared. China’s crackdown on video gaming for minors is consistent with its other crackdowns – for example, on cryptocurrencies – that decree that ‘the Chinese government knows what’s best for its people.’ However, libertarian western economies are unlikely to follow suit. In any case, even the World Health Organization concedes that gaming disorder affects only a small proportion of people.   Another regulatory issue is so-called ‘gamblification’. Popularly known as loot boxes, or mystery boxes, the contents of some in-game virtual goods are unknown to gamers who purchase them in the hopes of attaining rare items that boast high in-game utility. The features resemble gambling and raise concerns of predatory monetization. Calls for regulatory action refer to gamblification as a contributing cause to gaming disorder. Still, such features are not significant enough in most games to change the structural outlook. A final putative concern is that in-game tradable virtual currencies create a haven for cyber criminals and money launderers. The solution could be know-your-customer (KYC) and anti-money laundering (AML) regulations akin to those in the online gambling/betting industry. Ultimately, just as in the cryptocurrency space, and indeed the internet space, the crackdown and regulation of illicit activities should be welcomed, not feared. As such, it strengthens rather than weakens the structural outlook. The Investment Case This year’s sell-off in the interactive entertainment sector provides a good entry point for long-term investors (Chart I-9). The sell-off was exacerbated by two bits of bad news: first, the revelation of a toxic and sexist workplace culture at Activision Blizzard – since when the company has suffered a wave of bad publicity, numerous resignations, and a 40 percent plunge in its stock price; then, the Chinese crackdown on video gaming for minors. Chart I-9Interactive Entertainment’s Recent Sell-Off Provides A Good Long-Term Entry Point Interactive Entertainment's Recent Sell-Off Provides A Good Long-Term Entry Point Interactive Entertainment's Recent Sell-Off Provides A Good Long-Term Entry Point Both items of bad news seem well discounted. The sector’s relative valuation to the market has fallen below its long-term average. Even more striking, the sector now trades at a record 20 percent discount to the tech sector (Chart I-10 and Chart I-11). Chart I-10Interactive Entertainment Now Trades At A 20 Percent Discount To Technology… Interactive Entertainment Now Trades At A 20 Percent Discount To Technology... Interactive Entertainment Now Trades At A 20 Percent Discount To Technology... Chart I-11…And Its Relative Valuation To The Market Is Below The Long-Term Average ...And Its Relative Valuation To The Market Is Below The Long-Term Average ...And Its Relative Valuation To The Market Is Below The Long-Term Average Given that the structural outlook for the sector’s sales and profits remains intact, long-only investors with a minimum horizon of two years should buy the interactive entertainment sector (Table I-1). Hedge fund investors with a minimum horizon of two years should go long interactive entertainment versus technology. Chart I- Yet we think we can do better than the sector index by filtering out the riskiest stocks, based on overvaluation, commercial risk, and regulatory risk. For example, we exclude the Chinese stocks that are most exposed to the Chinese government crackdown and future whims.  Long-only investors with a minimum horizon of two years should buy the interactive entertainment sector. On this basis, our interactive entertainment basket comprises: (Table I-2). Chart I- Nintendo Activision Blizzard Electronic Arts Zynga Konami Capcom Square Enix   This is the final Counterpoint report of the year. We wish you all a very happy and restful holiday season.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Mohamed El Shennawy Research Associate mohamede@bcaresearch.com

Image The latest CPI and PPI prints at 6.2% and 8.6% respectively, have surprised economists on the upside. Indeed, this level of inflation was unseen in the US for the last forty years. However, there are early signs that input costs inflation is abating, thanks to a resolution of the supply chain bottlenecks and an appreciating dollar.  A proxy for the global manufacturing input cost inflation comprises of the Baltic Dry Index, DRAM, coal, and natural gas prices, is showing signs of easing (see chart). The US dollar is putting downward pressure on the price of commodities and also acts as a natural cooler to the global economic activity, helping resolve supply-demand imbalances. Resolution of the supply chain disruptions and falling prices of inputs will offer support for the Industrials sector, which has been languishing on the back of shortages and rising PPI. This thesis supports our structural overweight of the US Industrials and the US Manufacturing Renaissance theme. The rising dollar will support more domestically oriented asset classes and sectors, such as Small Cap (overweight) and Consumer Services industry groups (overweight). Conversely, the strong dollar will become a headwind for the Technology sector which derives 58% of sales from abroad, and whose goods will become more expensive for the overseas buyers.  Resolution of the shipping delays may hinder the performance of the Transportation Industry (overweight) which was reaping huge rewards from an outsized demand for shipping.  Bottom Line: Inflation will likely head lower over the coming 3-6 months while the dollar is rising. We are monitoring the effects of these macroeconomic developments on the performance of different segments of US equities. ​​​​​​​  

Chart 1 Revisiting EV Revolution Structural Investment Theme Revisiting EV Revolution Structural Investment Theme In June of this year, we published a Special Report on EV Revolution, recommending clients to add exposure to the structural electric vehicles (EV) theme to their portfolios. We continue to be bullish about the space and are reiterating our call. While the EV Revolution theme transcends GICS definitions, the S&P Autos & Components index remains the industry group with the highest EV exposure. It is dominated by Tesla and legacy automakers, Ford, and GM. Since our June Special Report, the sector outperformed the market by 34% (Chart 1). In the report, we posited that The Autos & Components industry group is in the middle of a momentous transition to electric and autonomous-vehicle manufacturing thanks to technological advances in battery storage, AI, and radars. Further, we noted that the entire EV ecosystem will benefit from government support for decarbonization, the preferences of millennials for green tech, and cutting-edge technological innovation. The recent passage of the Infrastructure bill with its green provisions are a certain positive for EVs. Chart 2 Revisiting EV Revolution Structural Investment Theme Revisiting EV Revolution Structural Investment Theme Tesla dominates the Auto industry group and accounts for roughly 75% of its market cap, thus dwarfing all other constituents. It had an amazing run since we made the call, doubling since June 21, 2021, when the report was published. While we are not stock-pickers, we believe that Tesla is a poster child of the theme: it sold 241,300 in the third quarter alone, which is over 100,000 than the same quarter last year - compare that to 367,500 vehicles in all of 2019. Tesla’s profitability is growing steadily (Chart 2), and so far, it was able to fend off challenges from competitors. Legacy Automakers, while crimped by the chip shortages and supply chain disruptions, are also likely beneficiaries of the theme: costs are high, but rewards are worth it: Higher earnings and greater economic visibility regarding EV transition should lead to eventual rerating of the industry group. These carmakers are also turning into Growth stocks as an expected surge in earnings is far in the future. In Table 1, we summarize the most popular EV ETFs. A more detailed description of each investment vehicle is in the appendix of the original report. Chart Bottom Line: We believe that the EV/AV theme will continue to outperform the US equity market over the 3-12 months horizon.

  Nearly two-thirds of the S&P 500 companies reported their Q3 earnings, and the earnings season is drawing to a close. 83% of companies have beaten the street expectations with an average earnings surprise standing at 11% (40% earnings growth vs. 29% expected on October 1, 2021). Sales beats are only marginally worse: 77% of the companies have exceeded expectations with an average sales surprise of 3%. Quarter-on-quarter earnings growth is 0.25% exceeding expected 6% contraction. Compared to Q3-2019, eps CAGR is 12%. Chart 1 Approaching The Finish Line Approaching The Finish Line Financials, Energy, and Health Care have delivered the largest earnings surprises. Financials have done well on the back of the robust M&A activity, while the unfolding energy crisis has lifted the overall S&P 500 Energy complex. Pent-up demand for the elective medical procedures has translated into strong Health Care earnings.   Industrials and Materials were amongst the worst: China-related headwinds continue to weigh on both of these sectors. However, some analysts expect China to ease in Q1-2022, providing a tailwind for these sectors.  Most companies commented that supply chain bottlenecks and soaring shipping costs are the major headwinds. However, as we see, most have navigated a challenging economic environment swimmingly. Strong pricing power and operating leverage have preserved margins and earnings so far. Looking ahead, companies’ ability to raise prices further is waning (Chart 1), while costs continue marching up. These factors are the ubiquitous reasons for a negative guidance – 52.6% of companies are guiding lower for Q4-2021 (compare that to 32.7% previous quarter). Bottom Line: Companies are exceeding analysts’ expectations both in terms of sales and earnings growth.     Chart

Highlights Increasing consumption should be a lot easier than increasing savings. After all, most people like to spend! It is getting them to work that should be challenging. Yet, the conventional wisdom is that deflation is a much tougher problem to overcome than inflation. It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town; fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring onerous financing costs. When the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. The pandemic banished the bond vigilantes. Governments ran massive budget deficits, but bond yields still dropped. While budget deficits will decline from their highs, fiscal policy will remain structurally more accommodative in the post-pandemic period. The combination of easier fiscal policy, increased household net worth, and other factors has raised the neutral rate of interest in the US and most other economies. This means that monetary policy is currently much more stimulative than widely believed. This is good news for equities and other risk assets in the near term, even if it does produce a major hangover down the road. New trade: Short US consumer discretionary stocks relative to other cyclicals. Consumer durable goods spending will slow as services spending and capex continue to recover. A Paradoxical Problem Economic pundits like to say that deflation is a tougher problem to overcome than inflation. We hear this statement so often that we do not think twice about it. In many respects, it is a rather strange perspective. Inflation results from too much spending relative to output, whereas deflation results from too little spending. Yet, people like to spend! One would think it would be much easier to get people to consume than to get them to work. The claim that deflation is a bigger problem than inflation is really just a statement about the limits of monetary policy. If the economy is overheating, central banks can theoretically raise rates as high as they want. In contrast, if the economy is in a deflationary funk, the zero-bound constraint limits how far interest rates can fall. Fortunately, there are other ways of stimulating the economy when interest rates cannot be cut any further. Most notably, governments can utilize fiscal policy by cutting taxes, spending more on goods and services, or increasing transfer payments. Getting Paid To Eat Lunch When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid for eating more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. This sounds so counterintuitive that it is worth thinking through a simple example. Suppose you currently earn $100,000 per year and expect your income to rise by 8% per year. You have $100,000 in debt, which incurs an interest rate of 3%, and want to keep your debt-to-income ratio constant at 100% over time. Next year, your income will be $108,000, so you should target a debt level of $108,000. Thus, this year, you can spend $105,000 on goods and services, make $3,000 in interest payments, and take on $8,000 in additional debt. Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay an additional $6,000 in interest, your cash outflows will exceed your income by $16,000, taking your debt to $216,000 — exactly twice next year’s income. Notice that by maintaining a higher debt balance, you can actually spend $5,000 more while still keeping your debt-to-income ratio constant. Appendix A proves this point mathematically. One might protest that the interest rate you face would be higher if you had more debt. Fair enough, although in our example, the interest rate would need to rise above 5.5% for spending to decline. The more important point is that unlike people, governments which issue debt in their own currencies get to choose whatever interest rate they want. Granted, if central banks set interest rates too low, the economy will overheat, leading to higher inflation. But this just reinforces the point we made at the outset, which is that inflation and not deflation is the real constraint to macroeconomic policy. A Blissful Outcome For Stocks We would not have waded through this theoretical discussion if it did not serve a practical purpose. In April of last year, we wrote a controversial report asking if, paradoxically, the pandemic could turn out to be good for stocks. Chart 1 We noted that by combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards a “blissful outcome” where the economy was operating at full capacity, yet interest rates were lower than they were before (Chart 1). If such a blissful state were reached, earnings would return to their pre-pandemic level, but the discount rate would remain below its pre-pandemic level, thus allowing stock prices to rise above their pre-pandemic peak. In the months following our report, the stock market played out this narrative.   From Blissful To Blissless? Chart 2Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate More recently, bond yields have risen, stoking fears that we are moving towards less auspicious conditions for equities. There is no doubt that many central banks are looking to normalize monetary policy. That said, what central banks regard as normal today is very different from what they thought was normal in the past. Back in 2012, when the Fed began publishing its “dot plot,” the FOMC thought the neutral rate of interest was around 4.25%. Today, it thinks the neutral rate is only 2.5%. And based on the New York Fed’s survey of market participants and primary dealers, investors believe the neutral rate is even lower than the Fed’s estimate (Chart 2). Even if the Fed did not face political pressure to keep interest rates low, it probably would not want to raise them all that much anyway. The same applies to most other central banks. Why The Neutral Rate Is Higher Than The Fed Believes There are at least four reasons to think that the neutral rate of interest is higher than what the Fed believes:   Reason #1: The drag on growth from the household deleveraging cycle is ending As a share of disposable income, US household debt has declined by nearly 40 percentage points since 2008. Debt-servicing costs are now at record low levels (Chart 3). The Fed’s Senior Loan Officer Survey points to an increasing willingness to lend (Chart 4). The Conference Board’s Leading Credit Index also remains in easing territory (Chart 5). Chart 3The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course Real personal consumption increased by only 1.6% in Q3. However, this was largely driven by a 54% drop in auto spending on the back of the semiconductor shortage. While vehicle purchases normally account for only 4% of consumer spending, the sector still managed to shave 2.4 percentage points off GDP growth in Q3. Chart 4Banks Are Easing Credit Standards Banks Are Easing Credit Standards Banks Are Easing Credit Standards Chart 5A Positive Signal For Credit Growth A Positive Signal For Credit Growth A Positive Signal For Credit Growth Spending on services rose by 7.9%, an impressive feat considering the quarter saw the peak in the Delta variant wave.   Reason #2: Fiscal policy is likely to remain accommodative in the post-pandemic period The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets (Chart 6). This point has not been lost on governments. While the flow of red ink will abate, the IMF estimates that the US cyclically-adjusted primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits (Chart 7). Chart 6 Chart 7 Chart 8A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Reason #3: Higher asset prices will bolster spending According to the Federal Reserve, US household net worth rose by over 113% of GDP between 2019Q4 and 2021Q2, the largest six-quarter increase on record (Chart 8). Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth, and 2-to-4 cents for every additional dollar of equity wealth. Based on the latest available data, we estimate that US homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption. And this does not even include any spending arising from the $2.4 trillion in incremental bank deposits that households have amassed since the start of the pandemic.    Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Reason #4: Population aging will drain savings Aging populations can affect the neutral rate either by dragging down investment demand or reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 9 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.8% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.5% over the next few decades. The average age of the US capital stock is now the highest on record (Chart 10). Whereas real business fixed investment is 6% below its pre-pandemic trend, core capital goods orders – a leading indicator for capex – are 17% above trend. Capex intentions remain near multi-year highs (Chart 11). All this suggests that investment spending is unlikely to fall much in the future. Chart 10The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record Chart 11Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Chart 12 In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 12). As baby boomers transition from net savers to net dissavers, national savings will fall. UnTaylored  Monetary Policy The Taylor Rule prescribes the Fed to hike rates by between 50-to-100 bps for each percentage point that output rises relative to its potential. Over the past decade, the Fed has favored the higher output gap coefficient, meaning that a permanent one percentage-point increase in aggregate demand should translate, all things equal, into a one percentage-point increase in the neutral rate of interest. Taken at face value, the combination of increased household wealth and looser fiscal policy may have raised the neutral rate in the US by more than five percentage points since the pandemic. This estimate, however, does not consider feedback loops: A higher term structure for interest rates would depress asset prices, thus obviating some of the wealth effect. Higher rates would also reduce the incentive for governments to run large budget deficits. Taking these feedback loops into account, a reasonable estimate is that the neutral rate in the US is about 2% in real terms, or slightly over 4% in nominal terms based on current long-term inflation expectations. This is close to the historic average for real rates, although well above current market pricing. The implication for investors is that US monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting. Higher Inflation Won’t Force The Fed’s Hand… Just Yet When will the Fed be forced to move away from its baby-step approach to monetary policy normalization and adopt a more aggressive stance? Our guess is not for another two years. Last week, we argued that inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps: Most of the recent increase in inflation has been driven by surging durable goods prices (Chart 13). Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation. Chart 13ADurable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Chart 13BDurable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) In modern service-based economies, structurally high inflation requires rapid wage growth. While US wage growth has picked up recently, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 14). The Fed welcomes this development, given its expanded mandate to pursue “inclusive growth.” At some point in the future, long-term inflation expectations could become unmoored. However, that has not happened yet, whether one looks at market-based or survey-based expectations (Chart 15). Thus, for now, investors should remain constructive on stocks. Chart 14Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Chart 15   New Trade: Short Consumer Discretionary Stocks Relative To Other Cyclicals We continue to favor cyclical stocks over defensives. Within the cyclical category, however, we are cautious on consumer discretionary names. Spending on consumer durable goods still has further to fall in order to return to trend. Durable goods prices will also come down, potentially squeezing profit margins. Go short the Consumer Discretionary Select Sector SPDR Fund (XLY) versus an S&P 500 sector-weighted basket of the Industrial Select Sector SPDR Fund (XLI), the Energy Select Sector SPDR Fund (XLE), and the Materials Select Sector SPDR Fund (XLB). Appendix A Image Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Image Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Image Current MacroQuant Model Scores Image

With 119 S&P 500 companies having reported Q3-2021 earnings, it’s time to take a pulse of the interim results. So far, the blended earnings growth rate is 34.8% while actual reported growth rate is 49.9%. The blended sales growth rate is 14.4%, while the actual reported rate is 16.6%. Analysts expected Q3-2021 earnings to be 6% below the Q2-2021 level. As of now, this quarter’s earnings are only 3% lower. Most of the companies that have reported are beating analysts’ forecasts are surprising to the upside. Currently, 83% of companies reported EPS above expectations, with five out of eleven sectors delivering an impressive 100% beat score. In terms of the magnitude of the beats, the overall number currently stands at 14% with Financials and Technology leading the pack. However, these results are bound to change as more companies report: less than 5% of the market cap has reported within the Energy, Materials, Real Estate, and Utilities sectors. The big theme for the current earnings season is input cost inflation. Many industrial giants, including Honeywell (HON), are complaining about supply-chain cost increases, and their potential adverse effect on margins. As a result, many companies are reducing guidance for the fourth quarter. So far, there are 59 positive pre-announcements, and 45 negative. On the bright side, the majority of companies are reporting that demand for their products remains strong, potentially offsetting some of the cost increases. This is especially the case with consumer demand: a few consumer staples companies, such as P&G, commented that their recent price hikes have not dampened demand for their products and have fortified their bottom line against rising costs. Bottom Line: The earnings season is gaining speed, and so far, it appears that Q3-2021 growth expectations are set at a low bar, that is easy to clear for most companies. Chart

Who Likes A Flattening Yield Curve? Who Likes A Flattening Yield Curve? In a recent daily report, we analyzed relative performance of the S&P 500 sectors and styles under different US 10-year Treasury yield (UST10Y) regimes. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the distinct US Treasury yield curve regimes, defined as a three-months change between 10-year and 2-year yields. To analyze sector and style performance by regime, we calculate contemporaneous three-months relative returns of sectors and styles. To summarize the results, we calculate median relative return of each sector/style in each regime. We subtract total period median to remove the sector and style biases in the long-term performance. In a flattening yield curve environment, Defensives, Quality, and Growth tend to outperform, as it indicates scarcity of growth. Accordingly, Real Estate, Technology, Utilities, and Communications Services also outperform. Yield curve steepening is usually associated with growth acceleration. This regime gives boost to more economically sensitive and capex intensive sectors and styles: Value, Small caps, and Cyclicals. Bottom Line: The shape of the US Treasury yield curve will be an important variable to monitor going forward, as it has a substantial effect on relative sector and style performance. ​​​​​​​

Next week is the BCA Annual Conference, at which I will debate Professor Nouriel Roubini on ‘The Outlook For Cryptocurrencies’. I will make the passioned case for cryptos, and Nouriel will make the passioned case against. I do hope that many of you can join the debate, as well as the other insightful sessions at the conference. As such, there will be no report next week and we will be back on October 28. Highlights The anomaly of the current ‘inflation crisis’ is not that goods and commodity prices have surged. The anomaly is that state intervention protected services prices from a massive (and continuing) negative demand shock. Absent the state intervention, there would not be the current ‘inflation crisis’. On a 6-12-month horizon: Underweight the durables-heavy consumer discretionary sector versus the market. Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Fractal analysis: Natural gas, plus industrial metals versus industrial metal equities. Feature Chart of the WeekServices Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Chart of the Week...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? The great writers, artists, and musicians tell us that the most profound messages often come from what is not said, not painted, and not played. What does not happen is sometimes more significant than what does happen. In this vein, we believe that the real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. The real story is that while goods and commodity prices have reacted exactly as would be expected to a positive demand shock, services prices have not reacted as would be expected to the mirror-image negative demand shock. The Anomaly Is Not Goods Prices, It Is Services Prices The following analysis quantifies the impact of the pandemic on different parts of the economy by examining the deviations of current spending and prices from their pre-pandemic trends. The analysis uses US data simply because of its timeliness and granularity, but the broad patterns and conclusions apply equally to most other developed economies. Looking at the overall economy, we know that, thus far, we have experienced neither a lasting negative demand shock from the pandemic, nor a lasting positive demand shock from the ensuing stimulus. We know this, because current spending is not far short of its pre-pandemic trend. The real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. Yet when we drill down to the components of spending, we see a different story. The pandemic and its policy response unleashed a massive and unprecedented displacement of spending from services to goods (Chart I-2). Chart I-2The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods By March 2021, while US spending on services was still below its pre-pandemic trend by $700 billion, or 8 percent, the displacement of those dollars of spending had boosted spending on the smaller durable goods component by 26 percent. Suffice to say, a 26 percent excess demand for durable goods cannot be satisfied by a modern manufacturing sector that utilises just-in-time supply chains and negligible spare capacity! As surging demand met relatively fixed supply, the price of durable goods skyrocketed to the current 11 percent above its pre-pandemic trend (Chart I-3). Chart I-3The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational It follows that the inflation in durables prices is the perfectly rational outcome of a classic positive demand shock – meaning, surging demand in the face of limited supply. What is much less rational is that a massive negative demand shock for services has had almost no negative impact on services prices. This is the untold story of the current ‘inflation crisis’ which requires further explanation. Government Intervention Prevented A Collapse In Services Prices If the pandemic had unleashed a classic negative demand shock for services, then services prices would have collapsed. We know this because in the aftermath of the global financial crisis (GFC), services prices fell below their pre-GFC trend exactly in line with the decline in services demand. But in the aftermath of the pandemic’s massive negative shock for services spending, services prices have remained on their pre-pandemic trend (Chart of the Week). The question is, how? The answer is that this was not a classic negative demand shock. The reason that service spending collapsed was that a large swathe of services – such as leisure and hospitality – became unavailable because of mandated shutdowns or lockdowns. In this case, there was no point in reducing prices to reattract demand from durable goods because nobody could buy these services anyway! In effect, while the goods sector remained subject to market forces, a large swathe of the service sector came under state intervention, and was no longer subject to market forces. Meanwhile, statisticians continued to record the seemingly unaffected price of eating out or going to the theatre, even though most restaurants and entertainment venues were shuttered, making their prices meaningless. Absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. Absent state intervention, these service providers would have had to reduce their prices to attract wary consumers amid a pandemic. This we know from Sweden, the one major economy that did not have any mandated shutdowns or lockdowns. While leisure and hospitality have remained largely open, Sweden’s services prices have declined markedly from their pre-pandemic trend – in sharp contrast to the unchanged trend in the US (Chart I-4). Chart I-4Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Hence, while inflation now stands at a sedate 2 percent in Sweden, it stands at a hot 5 percent in the US. If the US (and other country) governments had not intervened in the services sector, then the evidence from the GFC in 2008 and Sweden today strongly suggests that services prices would be below their pre-pandemic trend, offsetting goods prices that are above their pre-pandemic trend. The result would be that the overall price level would be on, or close to, its pre-pandemic trend. Just as overall spending is on its pre-pandemic trend. To repeat the key message of this analysis, the anomaly in most economies is not that goods and commodity prices have surged. The price surge is the perfectly rational response to a positive demand shock. The anomaly is that services prices did not react negatively to a negative demand shock (Chart I-5 and Chart I-6), as they did post-GFC and post-pandemic in non-interventionist Sweden. Chart I-5The Anomaly Is Not That Goods Prices ##br##Rose... The Anomaly Is Not That Goods Prices Rose... The Anomaly Is Not That Goods Prices Rose... Chart I-6...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall The untold story is that, absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. What Happens Next? The surging demand for durables is correcting. Since March, it is already down by 15 percent but requires a further 7 percent decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own! Meanwhile, as manufacturers respond with a lag to recent high prices, expect a tsunami of durables supply to hit in 6-12 months just as demand has fallen off a cliff. The result will be a major threat to any durable good or commodity price that has not already corrected. As a salutary warning of what lies ahead, witness the recent 75 percent crash in lumber prices. The same principle applies to non-durables such as food and energy. Non-durables spending is likely to fall back to its pre-pandemic trend, and non-durables prices are likely to follow. Again, outside a short-lived surge in demand from, say, a very cold winter, there is only so much energy and food that you can consume. For services, there are two opposing forces. The inflationary force is that the recent inflation in goods will transmit into wages and therefore into services prices. Against this, the deflationary force is that structural changes, such as hybrid home/office working, mean that services spending will struggle to make the near 6 percent increase to reach its pre-pandemic trend. Underweight the durables-heavy consumer discretionary sector versus the market. Pulling these effects together, we reiterate three investment recommendations on a 6-12 month horizon: Underweight the durables-heavy consumer discretionary sector versus the market (Chart I-7). Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Chart I-7As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms Natural Gas Prices Are Technically Extreme The surge in natural gas prices in both Europe and the US has reached a point of extreme fragility on its 130-day fractal structure. Hence, if the tight fundamentals show the slightest signs of abating, natural gas prices would be vulnerable to a sharp reversal (Chart I-8). Chart I-8Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Elsewhere, we see an arbitrage opportunity between industrial metal prices, which are still close to highs, and industrial metal equities, which have plunged by 20 percent since May. The relationship between the underlying metal prices and the metals equities sector is now stretched versus its history, and on its composite 65/130-day fractal structure (Chart I-9). Chart I-9The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched Hence, the recommended trade is to go short the LMEX Index/ long nonferrous metals equities. One way to implement the long side of the pair is through the ETF PICK. Set the profit target and symmetrical stop-loss at 8 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic 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 Electricity shortages in China are largely due to excessive power demand rather than a matter of shrinking electricity production. Chinese electricity consumption has been supercharged by the export sector’s booming demand for electricity. Excessive overseas (mainly US) demand for goods has been the main culprit behind China’s robust electricity demand. Divergence in the mainland economy between booming exports on the one hand and weakening property construction and infrastructure spending on the other hand will reduce the likelihood that policymakers will rush to stimulate. Odds are that Chinese and EM share prices will continue selling off and underperforming DM equities. Feature Contrary to popular perceptions, China’s electricity crisis is not due to drastic supply shortages but rather caused by excessive demand. This has implications for macro policy. Given that electricity shortages stem from strong demand, policymakers will be less aggressive in providing blanket stimulus over the near term. The basis is that unleashing more stimulus to boost the industrial sector – at a time when there are already scarcities of electricity and other inputs – will intensify the shortages and aggravate the situation. Robust Electricity Demand Electricity demand has been outstripping growing electricity output. Hence, shortages are largely due to excessive electricity demand. Charts 1 and 2 demonstrate that both electricity consumption and output have been expanding but demand growth has outpacing supply. Notably, electricity demand has surged above its trend by more than electricity production.  Chart 1Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chart 2Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend The mainland’s electricity demand has been strong due to surging manufacturing consumption of electricity. The top panel of Chart 3illustrates that electricity consumption in manufacturing has become overextended. On the other hand, residential demand for electricity has been expanding gradually and has not been excessive (Chart 3, bottom panel). The manufacturing sector has been supercharged by booming exports. Chart 4 reveals that China’s industrial output and exports have expanded briskly – their levels have surged well above their 10-year trend. Chart 3Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Chart 4Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Chart 5US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating DM countries’ stimulus has been responsible for this export boom. Specifically, US demand for goods has been running well above its pre-pandemic trend (Chart 5). Bottom Line: Both electricity consumption and production have been rising but demand has outstripped supply, resulting in shortages. On Supply Constraints Not only has total electricity output been rising but electricity produced by thermal coal has also been expanding, albeit gradually (Chart 6). China still generates 71% of its electricity using thermal coal. While electricity output growth from this source has slowed down recently, it has still not contracted (Chart 7). Chart 6China: Sources Of Electricity Production China: Sources Of Electricity Production China: Sources Of Electricity Production Chart 7Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted   Similarly, coal supply has been rising slowly, i.e., it has not shrunk (Chart 8). Coal supply has been capped due to the following reasons: Coal production has decelerated due to decarbonization policies adopted by Beijing. Authorities have also constrained coal mining by strictly enforcing safety protocols in mines following accidents early this year. Moreover, coal imports have been constrained by Beijing's ban on coal from Australia. Beijing’s “dual control” policy – which imposes targets on energy intensity and the level of energy consumption on provinces – has also led several local governments to reduce electricity production in recent weeks to ensure that annual targets are met. Finally, in recent years electricity prices have been flat-to-down while coal prices have surged (Chart 9). Thus, coal-based power generators have recently been incurring losses and some of them have been reluctant to produce more electricity. Chart 8China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid   Chart 9Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses   Authorities have begun tackling these problems. Coal supply will likely rise moderately as will electricity output from thermal coal. Reportedly, some Australian coal has in recent days been offloaded in China, and authorities have eased restriction on coal production and encouraged banks to lend to coal producers and electricity generators. Bottom Line: There has been a slowdown – not a contraction – in electricity produced by thermal coal. Authorities have started addressing these bottlenecks and odds are that electricity output will catch up with electricity demand before year-end, i.e., the power shortages will likely gradually ebb. Implications For Chinese Macro Policy Given that electricity demand has been outstripping supply, clients might wonder about the pace of China’s economic growth. This has ramifications as to whether or not authorities will stimulate aggressively. On the one hand, the manufacturing and especially export-oriented segments have been expanding briskly. As shown in Chart 4 above, manufacturing output in general and exports in particular have been overheating. Further, the labor market has been tightening, as is illustrated in Chart 10. On the other hand, as we have been writing, construction and infrastructure spending have been weakening (Chart 11). Chart 10China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight Chart 11Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Granted property developers, local governments and LGFVs are facing debt limits and financing constraints, it is safe to assume that they will cut back on their capital spending. China’s construction and infrastructure spending accounts for a large share of industrial metals demand. This is a basis for our argument that industrial metal prices remain at risk of declining. Unlike the current power crunch, industrial metal shortages are not caused by excessive demand but rather are due to shrinking production. Chart 12 shows that China’s steel output has contracted. Hence, the surge in steel prices has been due to production cutbacks. Local governments are probably shutting down metals production in response to decarbonization policies and to divert power to export-oriented companies. The fact that the price of steel’s key ingredient – iron ore – has collapsed is consistent with reduced demand for it (Chart 13). This is in contrast with the current strong demand for coal. Chart 12Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Chart 13Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Overall, the bifurcation in the economy characterized by booming exports versus weakening property construction and infrastructure spending reduces the likelihood that policymakers will rush to stimulate. Rather, they will provide targeted support to negatively affected segments of the economy in the form of easier credit access, easing industry regulation and easier decarbonization targets. Bottom Line: Policymakers in Beijing will not rush to provide a blanket stimulus for now. Rather, they will use this period of booming exports to undertake deleveraging in the real estate sector as well as local governments and their affiliated companies. Investment Implications: Barring any large stimulus, construction and infrastructure spending will continue to disappoint, which is bad for industrial metals. This outlook in combination with the ongoing regulatory clampdown on internet companies heralds lower prices for Chinese investable stocks. Chart 14Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Given that Chinese investable stocks include few export companies, booming exports will not be sufficient to propel China’s MSCI Investable equity index higher. Among the Chinese indexes, we reiterate our long A shares / short China MSCI Investable index strategy, a recommendation made in early March (Chart 14). Reshuffling The EM Portfolio BCA’s Emerging Markets Strategy team is recommending the following changes in country allocation within EM equity and fixed-income portfolios. Equities: We are downgrading Indian stocks from overweight to neutral. The reasons for this portfolio shift are presented in the country report we are publishing today. In its place, dedicated EM equity managers should upgrade Russian and Central European equity markets like Poland, Czech Republic and Hungary from neutral to overweight. The rationale is that high oil prices favor Russian equity outperformance. Barring a major crash in oil prices, we are comfortable maintaining an overweight allocation to Russia in an EM portfolio. ​​​​​​​In turn, rising bond yields in core Europe are positive for bank stocks that have a large weight in Central European bourses.   Fixed Income: We are upgrading Russian local currency bonds from neutral to overweight within an EM domestic bond portfolio. A hawkish central bank is positive for the long end of the Russian yield curve. 10-year yields also offer great value. Further, high energy prices (even if they drop from current very elevated levels but remain above $60 per a barrel) will help the ruble to outperform its EM peers. We maintain a yield curve trade of receiving 10-year/paying 1-year swap rates in Russia. Finally, we continue overweighting Russian sovereign and corporate credit within an EM credit portfolio.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations