Disasters/Disease

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

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, October 7 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth has peaked, but at very high levels. Progress on the vaccination campaign, along with continued accommodative monetary and fiscal policies, should keep recession risks at bay for the foreseeable future. Global Asset Allocation: Remain overweight stocks. While the risk-reward profile for equities is not as appealing as it was last year, the TINA theme (“There Is No Alternative” to equities) will continue to resonate with investors. Equities: Favor cyclicals, small caps, value stocks, and non-US equities. Long EM is an attractive contrarian play. Fixed Income: Maintain slightly below average interest-rate duration exposure. The US 10-year Treasury yield will rise to 1.8% by the first half of next year. Spread product will continue to outperform high-quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. The Canadian dollar will be the best performing DM currency during the remainder of the year. Commodities: Oil prices will remain firm, bucking market expectations of a decline. Metals may be at the cusp of a new supercycle. I. Macroeconomic Outlook Global Growth To Remain Above Trend Global growth has peaked, but at very high levels. According to Bloomberg consensus estimates, real GDP in the G7 rose by 6.0% in Q3, down from 6.8% in Q2 (Table 1). G7 growth is expected to soften to 4.9% in Q4, mainly reflecting somewhat softer growth in Europe following a blistering third quarter which saw real GDP expand by more than 9% in the UK and the euro area. Table 1Global Growth Will Remain Above Trend Well Into Next Year 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Not all countries have reached peak growth. Japan is projected to see faster growth in Q4, with GDP rising by 3.8% compared to 1.6% in Q3. Canadian growth should pick up from 4.5% in Q3 to 5.8% in Q4. Australia’s economy is projected to grow by 7.4% in Q4 after having contracted by 10.7% in Q3. Chinese growth is expected to accelerate to 5.9% in Q4 from 2.6% in Q3. Across almost all the major economies, growth should remain at an above-trend pace in 2022. G7 growth is expected to hit 4.1%, well above the trend rate of 1.4%. Usually when growth peaks, investors start to worry that a recession is around the corner. Given that growth is coming down from exceptionally high levels, this is not a major risk at the moment. Most Countries Are Easing Lockdown Restrictions Ten months after the first Covid vaccines became publicly available, 3.5 billion people, or 45% of the world’s population, have received at least one shot (Chart 1). At this point, most people in developed economies who want a vaccine have been able to receive one. Chart 1Nearly Half Of The World's Population Has Received At Least One Covid Vaccine Shot 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song While vaccine availability in many emerging markets remains a problem, the situation is improving rapidly. India is currently vaccinating 7.5 million people per day. Over 45% of Indians have had at least one shot, something that would have seemed unfathomable just a few months ago. New medications are on the way. Just today, Merck announced a breakthrough pill that lowers the risk of hospitalization from Covid by 50%. Globally, the number of new daily cases has fallen from over 650,000 in August to 450,000 today. Lower case counts, along with increased vaccinations, have allowed most countries to loosen lockdown measures. Goldman’s Effective Lockdown Index has eased to the lowest level since the start of the pandemic (Chart 2). Chart 2Covid Restrictions Are Easing In Many Places 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Monetary Policy: The Slow March To Neutral As the pandemic recedes from view, central banks are starting to dial back monetary support. Last week, Norway became the first major developed economy to hike rates. New Zealand, having already ended QE, may raise rates before the end of the year. Other central banks are looking to normalize policy. The Bank of Canada has cut its asset purchases in half. The Reserve Bank of Australia has begun tapering asset purchases. The Swedish Riksbank has indicated that it will end asset purchases this year. The Fed will formally announce the tapering of asset purchases in November, while the Bank of England’s latest round of QE expansion will expire in December. The ECB, Swiss National Bank, and Bank of Japan remain firmly in the dovish camp. That said, the ECB has cracked open the exit door ever so slightly by announcing that it will stop buying assets through the Pandemic Emergency Purchase Programme in March (The ECB will continue to buy bonds under the existing Asset Purchase Programme, however). Taper Tantrum Redux? The prospect of Fed tapering has stoked worries of a replay of the 2013 Taper Tantrum. We think such worries are overstated. For one thing, tapering is not the same thing as tightening. The Fed will still be adding to the size of its balance sheet; it will simply be doing so at a diminished pace. Thus, tapering implies a slower pace of easing rather than outright tightening, a subtle but important distinction. Tapering could be regarded as tightening if, as in 2013, the very act of tapering sends a signal to investors that rate hikes are forthcoming. However, in the years following the Taper Tantrum, the Fed has gone out of its way to delink balance sheet policy from interest rate policy, stressing that the two are substitutes not complements.  The Fed is unlikely to start hiking rates until late 2022 or early 2023. It will probably take another year or two beyond then for interest rates to rise into restrictive territory, and even longer for the lagged effects of monetary policy to work their way through to the economy. There is an old saying: “Expansions don’t die of old age. They get murdered by the Fed.” The Fed will probably kill the expansion. However, the deed is unlikely to be committed until 2024 at the earliest, giving the bull market in stocks further scope to continue. Fiscal Policy: Tighter But Not Tight On the fiscal side, the IMF expects the aggregate cyclically-adjusted primary budget deficit in advanced economies to decline from 7.7% of GDP in 2021 to 3.7% of GDP in 2022, implying a negative fiscal impulse of 4% of GDP. Normally, such a negative fiscal impulse would weigh heavily on growth. However, since this fiscal tightening is set to occur against a backdrop of continued strong private domestic demand growth, the economic fallout should be limited. The absolute stance of fiscal policy also matters. While budget deficits will decline over the next few years, the IMF expects deficits to be larger in the post-pandemic period than they were before the pandemic (Chart 3). Chart 3Fiscal Policy: Tighter But Not Tight 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song If anything, the IMF’s projections understate the likely size of future budget deficits as they do not incorporate any fiscal measures that have yet to be signed into law. These include the proposed $550 billion US infrastructure bill, an election-season stimulus package in Japan, and increased investment spending by what is likely to be a center-left coalition government in Germany. Chart 4Plenty Of Pent-Up Demand 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Perhaps one of the most important, and largely overlooked, consequences of the pandemic is that the bond vigilantes have been banished into exile. Governments ran record budget deficits last year and bond yields fell anyway. Post-pandemic fiscal policy is likely to end up being structurally more expansionary than it was following the Global Financial Crisis. Plenty Of Dry Powder It should also be noted that not all the stimulus funds that have been disbursed have made their way into the economy. US households are currently sitting on $2.4 trillion in excess savings, equivalent to about 15% of annual consumption (Chart 4). About half of these excess savings stem from decreased spending on services during the pandemic. The other half stem from increased transfer payments – stimulus checks, unemployment insurance benefits, and the like. Some investors have expressed concern that these savings will remain idle. Among other things, they note that a record high share of households in the University of Michigan survey think that this is a bad time to be purchasing big-ticket items (Chart 5). Chart 5Consumers Are Deferring Purchases Of Big-Ticket Items In Anticipation Of Lower Prices Consumers Are Deferring Purchases Of Big-Ticket Items In Anticipation Of Lower Prices Consumers Are Deferring Purchases Of Big-Ticket Items In Anticipation Of Lower Prices Chart 6Improving Consumer Confidence Will Buoy Consumption Improving Consumer Confidence Will Buoy Consumption Improving Consumer Confidence Will Buoy Consumption We would downplay these concerns. A review of the evidence from the original CARES act suggests that households spent about 40% of the stimulus checks within three months of receiving them. That is a reasonably high number considering that precautionary savings typically rise during times of economic uncertainty. Despite the improvements in the economy, consumer confidence remains below pre-pandemic levels. There is a strong correlation between consumer confidence and household consumption (Chart 6). As confidence continues to recover, household spending should hold up well. As far as the reluctance to buy big-ticket items is concerned, we would paint this in a positive light. When households are asked why they are not in a rush to buy, say, a new automobile, they answer, quite rationally, that they expect prices to fall and availability to improve. Concerns over job security are far down on the list. In this sense, the market mechanism is doing what it is supposed to do: Supplying goods to those who are willing to pay up in order to get them immediately, while giving those with a bit more patience the opportunity to buy them later at a lower price.  Chart 7Firms Will Need To Maintain High Production To Replenish Inventories Firms Will Need To Maintain High Production To Replenish Inventories Firms Will Need To Maintain High Production To Replenish Inventories From a macro perspective, this means that demand for durable goods is unlikely to fall off a cliff anytime soon. There is enough pent-up demand around to ensure production stays buoyant well into next year. This is especially the case for autos, where nearly half of US shoppers have decided to defer purchases. And with inventory levels at record lows, firms will need to produce more than they sell (Chart 7). It is difficult to see growth slowing dramatically in such an environment. Pandemic-Induced Inflation Spike Should Fade The willingness of households to postpone spending until supply has had a chance to catch up to demand should help mitigate inflationary pressures. It would be much worse if households thought that today’s high consumer goods prices presaged even higher prices down the road. Such a dynamic could easily unmoor inflation expectations, forcing the Fed into action. Despite the recent spike in inflation, household long-term inflation expectations have not increased that much. Inflation expectations 5-to-10 years out in the University of Michigan survey ticked up to 3% in September. While this is above the average level of 2.5% in 2017-2019, it is broadly within the range of expectations that prevailed between 1997 and 2014 (Chart 8). Chart 8Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Chart 9Wages At The Bottom End Of The Distribution Are Rising Briskly Wages At The Bottom End Of The Distribution Are Rising Briskly Wages At The Bottom End Of The Distribution Are Rising Briskly Chart 10Strong Wage Growth In The Leisure And Hospitality Sector 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Wages have risen briskly at the bottom end of the income distribution (Chart 9). The jump in wage growth in the leisure and hospitality sector – where workers have been given the unenviable task of enforcing mask mandates and other requirements – has been particularly pronounced (Chart 10). However, wage growth for high-skilled salaried employees has been flat-to-down. As a consequence, overall wage growth, as measured by the Atlanta Fed Wage Tracker, has moved sideways. Rising CPI inflation remains contained to only a few categories. Median CPI inflation registered 2.4% in August, below where it was in late 2019. Excluding vehicle prices, the level of the core CPI remains below its pre-pandemic trend line (Chart 11). Chart 11Unwinding Of "Base Effects" Core Inflation With And Without Autos Unwinding Of "Base Effects" Core Inflation With And Without Autos Unwinding Of "Base Effects" Core Inflation With And Without Autos Recent indications suggest that used car prices have peaked (Chart 12). Memory prices are trending lower, suggesting that the worst of the semiconductor shortage may be behind us (Chart 13). The Drewry World Container Index also inched lower this week for the first time in five months. Chart 12Used Car Prices Have Peaked Used Car Prices Have Peaked Used Car Prices Have Peaked Chart 13Memory Chip Prices Are Edging Lower Memory Chip Prices Are Edging Lower Memory Chip Prices Are Edging Lower In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. II. Feature: The Real Risk From China’s Property Market Chart 14The Demographic Turning Point In Japan And China The Demographic Turning Point In Japan And China The Demographic Turning Point In Japan And China Lehman Moment Or Japan Moment? The turmoil surrounding Evergrande, one of China’s largest property developer, has sparked fears that China is experiencing its own “Lehman moment”. Such worries are misplaced. The Chinese government has enough control over the domestic financial system to keep systemic risks in check. The more appropriate analogy is not with Lehman, but with Japan. The Japanese property bubble burst in the early 1990s, sending the country into a prolonged deflationary funk. As was the case in Japan three decades ago, Chinese property prices are very high in relation to incomes. Moreover, as was the case in Japan, China’s working-age population has peaked, which is likely to translate into lower demand for housing down the road (Chart 14). As it is, studies using night light data suggest that 20% of apartments are sitting vacant. Similar to Japan, debt has fueled China’s housing boom. Chinese property developers are amongst the most leveraged in the world (Chart 15). Households have also been borrowing aggressively: Mortgage debt has risen from around 15% of GDP in 2010 to 35% of GDP (Chart 16). Chart 15Rising Leverage Ratios In China's Real Estate Sector Rising Leverage Ratios In China's Real Estate Sector Rising Leverage Ratios In China's Real Estate Sector Chart 16Mortgage Debt Has Been On The Rise In China Mortgage Debt Has Been On The Rise In China Mortgage Debt Has Been On The Rise In China Differences With Japan Despite the clear parallels between Japan in the early 1990s and China today, there are a number of key differences. First, Japan was already an advanced economy in the early 1990s. Today, labor productivity in China is still 40% of what it is in neighbouring South Korea (and 25% of what it is in the US). As productivity in China continues to rise, GDP will increase, even if the number of workers continues to shrink. As Chart 17 shows, China would need to grow by at least 6% per year over the next decade for output-per-worker to converge to South Korean levels by the middle of the century. It is easier to reduce leverage when incomes are growing quickly. Second, while real estate investment in China is still too high for what the country needs, it has been falling as a share of GDP since 2014 (Chart 18). This is not obvious from the monthly fixed asset investment data that investors track because this data counts land purchases as investment. Chart 17China: A Lot Of Catch-Up Potential China: A Lot Of Catch-Up Potential China: A Lot Of Catch-Up Potential Chart 18Chinese Real Estate Construction Peaked Years Ago Chinese Real Estate Construction Peaked Years Ago Chinese Real Estate Construction Peaked Years Ago   Property developers have been buying land and holding on to it in anticipation that it will appreciate in value. This carry trade will end, but the impact on the real economy may be limited if, as is likely, the assets of bankrupt property developers end up being shuffled into quasi state-owned entities, allowing existing housing projects to continue. After all, if the goal of the government is to make housing more affordable, stopping construction would be precisely the wrong thing to do. Third, China has learned from Japan’s policy mistakes, especially when it comes to the appropriate role for government stimulus in the economy. Japan’s biggest mistake in the 1990s was not that it failed to listen to western experts, but that it listened to them too much. The whole narrative about how Japan could have revived its economy through “structural reforms” never made any sense. Japan’s problem was not one of poor resource allocation; it was one of inadequate demand: The property sector collapsed, leaving a big hole in GDP that needed to be filled. Shutting down “zombie companies” arguably made things worse, not better. Chinese Stimulus On The Way Standard debt sustainability equations imply that paradoxically, a country with a high debt-to-GDP ratio can run a larger primary budget deficit than a country with a low debt-to-GDP ratio, while still achieving a stable debt-to-GDP ratio over time.1  In China’s case, bond yields are well below nominal GDP growth, which gives the government significant fiscal leeway (Chart 19). The Ministry of Finance has expressed its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. Increased bond issuance will allow local governments to trim their reliance on land sales to finance spending. For its part, the PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 20). With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. Chart 19Chinese Bond Yields Are Well Below Nominal GDP Growth Chinese Bond Yields Are Well Below Nominal GDP Growth Chinese Bond Yields Are Well Below Nominal GDP Growth Chart 20A Positive Sign For Credit Growth In China A Positive Sign For Credit Growth In China A Positive Sign For Credit Growth In China   Chart 21China Suffers From High Levels Of Inequality 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Rebalancing The Chinese Economy Over the long haul, China will need to encourage consumer spending in order to allow for the continued contraction of the construction industry without depressing overall employment. At 38% of GDP, China’s consumption share is one of the lowest in the world. A weak social safety net has forced Chinese households to maintain high levels of precautionary savings. Rampant inequality has shifted income towards richer households which tend to save more than the poor (Chart 21). Sky-high home prices only amplified the need to save more to buy a flat. All this has depressed overall consumption. For all its faults, President Xi’s “common prosperity” campaign could help redress all three of these problems, ultimately creating a stronger and more balanced economy. In summary, while China does represent a risk to the global economy, the threat at the moment is not severe enough to warrant turning bearish on equities and other risk assets. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Investors often express skepticism about the benefits of using macroeconomics as an input into their investment process. Charts 22 and 23 should dispel such doubts. The charts show that the business cycle is by far the most important driver of equity returns over medium-term horizons of 6-to-18 months. Chart 22The Business Cycle Drives Cyclical Swings In Stocks (I) The Business Cycle Drives Cyclical Swings In Stocks (I) The Business Cycle Drives Cyclical Swings In Stocks (I) Chart 23AThe Business Cycle Drives Cyclical Swings In Stocks (II) The Business Cycle Drives Cyclical Swings In Stocks (II) The Business Cycle Drives Cyclical Swings In Stocks (II) Chart 23BThe Business Cycle Drives Cyclical Swings In Stocks (II) The Business Cycle Drives Cyclical Swings In Stocks (II) The Business Cycle Drives Cyclical Swings In Stocks (II) For the most part, the change in the value of the stock market is closely correlated with the level of economic growth. As noted earlier, global growth is peaking but at very high levels. This suggests that stock returns will be reasonably strong over the next 12 months, although not as strong as they were over the preceding 12 months. Higher Bond Yields Unlikely To Undermine The Stock Market Treasury yields have moved up since the conclusion of the FOMC meeting on September 22nd. The market narrative of a “hawkish surprise” does not make much sense to us. The yield curve usually flattens after a central bank delivers a hawkish surprise. That is what happened following the June FOMC meeting. This time around, the 2-10 curve has steepened by 13 basis points. Our sense is that the rise in bond yields mainly reflects the lagged effect from the decline in Covid cases, along with the realization that the pandemic-induced rise in inflation may be a bit stickier than previously believed. Equities often suffer some indigestion when bond yields rise. However, history suggests that as long as yields do not increase enough to imperil the economy, stocks usually end up recovering and reaching new highs (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song The 10-year Treasury yield has already risen halfway to our 2022H1 target of 1.8%. Any further upward move is likely to be more gradual than what has transpired over the past few weeks. As such, we expect the pressure on stocks to diminish. The fact that bearish sentiment in the AAII survey reached a one-year high this week suggests we may be nearing a bottom in stocks. Ultimately, TINA’s siren song will be impossible to resist. What Is The True ERP? While equity valuations are not cheap, they are not at extreme levels either. The MSCI All-Country World Index currently trades at 18-times forward earnings. Unlike in most years, analysts have been revising up earnings estimates this year, both in the US and abroad (Chart 24). This suggests the currently quoted forward PE ratios are not excessively optimistic. Chart 24Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year Chart 25The Global Equity Risk Premium Is Elevated The Global Equity Risk Premium Is Elevated The Global Equity Risk Premium Is Elevated Relative to bonds, stocks still trade at a healthy discount. The forward earnings yield for the MSCI All-Country World index is 640 basis points above the global real bond yield (Chart 25). Even in the US, where valuations are more stretched, the implied equity risk premium (ERP) stands at 580 basis points. Amazingly, this is exactly where the US ERP stood in May 2008. The equity risk premium, as measured by the gap between the earnings yield and the real bond yield, will overstate the magnitude to which stocks are expected to outperform bonds if the PE ratio ends up falling over time. Nevertheless, for stocks to underperform bonds, PE multiples would need to fall by an implausibly large amount. For example, suppose US companies manage to grow real EPS by a modest 2.5% per year over the next decade. The US dividend yield is 1.3%. Assuming dividends rise in line with earnings, investors would receive a real total return of 3.8%. The 10-year TIPS yield is -0.9%. Thus, the US PE multiple would need to shrink by an average of 4.7% (3.8% plus 0.9%) per year over the next 10 years for stocks to underperform bonds on a real total return basis. This would take the US forward PE multiple down to 13. It is not unfathomable that the US PE multiple would fall this much. However, as a baseline scenario, it is too pessimistic. A more plausible baseline forecast would be a terminal PE multiple of 18. That would be consistent with a “true” ERP of 3%.   B. Equity Sectors, Regions, And Styles Favor Cyclicals, Value Stocks, And Small Caps As one might expect, cyclical equity sectors tend to outperform defensives in strong growth environments (Chart 26). The pandemic has exposed a shortage of industrial capacity across a wide range of industries from semiconductors to automobiles. US capital goods shipments have lagged orders for 18 straight months (Chart 27). Industrial stocks stand to benefit from increased capital spending. Materials and energy stocks will gain from strong commodity prices and a weaker US dollar (Chart 28). Chart 26Strong Growth Favors Cyclicals Strong Growth Favors Cyclicals Strong Growth Favors Cyclicals Chart 27US Capital Goods Shipments Have Lagged Orders US Capital Goods Shipments Have Lagged Orders US Capital Goods Shipments Have Lagged Orders   Chart 28Materials And Energy Stocks Will Gain From Strong Commodity Prices And A Weaker US Dollar Materials And Energy Stocks Will Gain From Strong Commodity Prices And A Weaker US Dollar Materials And Energy Stocks Will Gain From Strong Commodity Prices And A Weaker US Dollar Like cyclicals, value stocks do best during periods when global growth is strong and the US dollar is weak (Chart 29). Rising bond yields should help bank shares, which are heavily overrepresented in value indices (Chart 30). In contrast, tech shares, which are overrepresented in growth indices, usually struggle in rising yield environments. Value stocks are also cheap – three standard deviations cheap based on a simple composite valuation measure that compares price-to-earnings, price-to-book, and dividend yields (Chart 31). Chart 29Value Stocks Typically Do Well When The Dollar Is Depreciating Value Stocks Typically Do Well When The Dollar Is Depreciating Value Stocks Typically Do Well When The Dollar Is Depreciating Chart 30Higher Yields Are A Boon For Banks And A Bane For Tech 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song   Chart 31Value Is Cheap Value Is Cheap Value Is Cheap Financials and industrials are overrepresented in US small caps indices, while tech and communication services are underrepresented (Table 3). Thus, it is not surprising that small caps usually outperform their large cap peers when growth is strong, the dollar is weakening, and bond yields are rising (Chart 32). Table 3Financials And Industrials Have A Larger Weight In US Small Caps 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Like value stocks, small caps are reasonably priced. The S&P 600 small cap index trades at 16-times forward earnings, compared to 17-times for the S&P 400 mid cap index and 21-times for the S&P 500 (Chart 33). Small cap earnings are also expected to grow by 30% over the next 12 months, easily beating mid caps (19%) and large caps (15%). BCA’s relative valuation indicator suggests that, compared to large caps, small caps are now as cheap as they were in the late 1990s (Chart 34). Chart 32US Small Caps Tend To Outperform When Growth Is Strong, The Dollar Is Weakening, And Bond Yields Are Rising 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song   Chart 33US Small Caps Are Not Expensive US Small Caps Are Not Expensive US Small Caps Are Not Expensive Chart 34US Small Caps Are Attractive Relative To Large Caps US Small Caps Are Attractive Relative To Large Caps US Small Caps Are Attractive Relative To Large Caps Regional Equity Allocation: Better Prospects Outside The US Stock markets outside the US have more of a cyclical/value tilt (Table 4). Hence, they tend to fare best when global growth is strong and the dollar is weakening (Chart 35). Table 4Cyclicals Are Overrepresented Outside The US 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Chart 35Strong Growth And A Weaker Dollar Is Good For Non-US Stocks 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Probable tax changes could hurt the relative performance of US stocks. BCA’s geopolitical strategists expect the Democrats to raise the corporate tax rate from 21% to about 26%. Additional tax hikes are likely to apply to overseas earnings, something that will disproportionately affect tech companies. Non-US stocks are reasonably priced, trading at a forward PE ratio of 15. EM equities are especially cheap. They currently trade at a forward PE ratio of 13 (Chart 36). The EM discount to the global index is as large now as it was during the late 1990s. Chart 36AEM Equities Are Trading At A Large Discount (I) 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Chart 36BEM Equities Are Trading At A Large Discount (II) 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song After a blistering period of rapid earnings growth during the 2000s, EM EPS has been trending sideways during the past decade (Chart 37). However, the combination of increased global capital spending and rising commodity prices should buoy EM profits in the years ahead. Improved performance from EM banks should also help. Chinese banks are trading at 4.2-times forward earnings, 0.5-times book, and sport a dividend yield of over 6% (Chart 38). Such valuations discount too much bad news. Chart 37AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade(I) 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Chart 37BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song   Chart 38Chinese Banks: A Lot Of Bad News Is Discounted Chinese Banks: A Lot Of Bad News Is Discounted Chinese Banks: A Lot Of Bad News Is Discounted Chart 39Chinese Tech Stocks Underperformed Their Global Peers This Year Chinese Tech Stocks Underperformed Their Global Peers This Year Chinese Tech Stocks Underperformed Their Global Peers This Year Outlook For Chinese Tech Stocks The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 46% since February (Chart 39). Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 15.9-times 2021 earnings, Baidu is trading at 17.1-times earnings, and Tencent is trading at 27.1-times earnings. In comparison, the NASDAQ Composite trades at 31.9-times 2021 earnings.   C. Fixed Income Why Are Bond Yields So Low Even Though Inflation Is So High? While global bond yields have moved higher in recent days, they remain well below pre-pandemic levels. Investors are understandably puzzled about how today’s high inflation rates can coexist with such low bond yields. Two explanations stand out: First, despite the recent uptick in inflation expectations, investors still believe inflation will come down and stay down (Chart 40). In fact, the 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s comfort zone, suggesting that investors expect inflation to ultimately undershoot the Fed’s target. Chart 40AInvestors Expect Inflation To Fall Rapidly From Current Levels (I) 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Chart 40BInvestors Expect Inflation To Fall Rapidly From Current Levels (II) Investors Expect Inflation To Fall Rapidly From Current Levels Investors Expect Inflation To Fall Rapidly From Current Levels Chart 41The Market Thinks The Fed Will Raise Rates Only To 2% The Market Thinks The Fed Will Raise Rates Only To 2% The Market Thinks The Fed Will Raise Rates Only To 2% Second, and related to the point above, investors believe that the neutral rate of interest is very low. According to the New York Fed’s survey of market participants, investors think that the Fed will not be able to raise rates above 2% during the forthcoming tightening cycle (Chart 41). This is even lower than the terminal rate of 2.5% that the Fed foresees. When the Federal Reserve first introduced the dot plot back in 2012, it believed the neutral rate was 4.25%. If the neutral rate really is this low, then monetary policy is not as hyperstimulative as is often asserted. In that case, a 10-year yield of 1.5% would be entirely appropriate given that it will take a few years for rates just to reach 2%. Indeed, an even lower yield could be justified on the grounds that there is a high probability that the economy will be hit by an adverse shock over the next decade, requiring a return to zero rates and more QE. Maintain Below-Benchmark Duration Our view is that the neutral rate is higher than most market participants believe. The end of the household deleveraging cycle in the US, structurally looser fiscal policy, and the exodus of well-paid baby boomers from the labor market will all deplete national savings, pushing up the neutral rate of interest in the process. If a central bank underestimates the neutral rate, it is liable to keep interest rates too low for too long. This could cause inflation to rise more than anticipated, putting further upward pressure on bond yields. It will take some time for the market’s view to converge to our view (provided we are correct, of course!). Investors have bought into the secular stagnation thesis hook, line, and sinker. Thus, they will require plenty of evidence that the Fed can raise rates without strangling the economy. We expect the US 10-year yield to move to 1.8% by early next year, warranting a moderately below-benchmark duration stance. US Treasuries have a higher beta than most other government bond markets (Chart 42). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 42US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets Chart 43High-Yield Spreads Are Pricing In A Default Rate Of More Than 3% High-Yield Spreads Are Pricing In A Default Rate Of More Than 3% High-Yield Spreads Are Pricing In A Default Rate Of More Than 3% Corporate Bonds: Favor High Yield Over Investment Grade BCA’s bond strategists see more upside for high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 3.15% (Chart 43). This is more than their fair-value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.8%. Our bond team also sees USD-denominated EM corporate bonds as being attractively priced relative to domestic US investment-grade corporate bonds with the same duration and credit rating.   D. Currencies And Commodities Fade Recent Dollar Strength The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). The US dollar has strengthened in recent weeks, spurred on by a more cautious tone to markets (the VIX is around 22, up from 16 in late August). As risk sentiment improves, the dollar will weaken. The composition of global growth also matters. Growth momentum is rotating from the US to the rest of the world. The dollar usually struggles when this happens (Chart 45). Chart 44The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 45Growth Momentum Is Shifting Outside The US, Which Should Weigh On The Dollar Growth Momentum Is Shifting Outside The US, Which Should Weigh On The Dollar Growth Momentum Is Shifting Outside The US, Which Should Weigh On The Dollar Despite the uptick in US yields, short-term real rate differentials are heavily skewed against the dollar (Chart 46). The US trade deficit has surged over the past 16 months (Chart 47). Equity inflows have been financing the trade deficit, but these could tail off if US stocks start to lag their overseas peers. Chart 46Short-Term Real Rates Remain Skewed Against The Dollar Short-Term Real Rates Remain Skewed Against The Dollar Short-Term Real Rates Remain Skewed Against The Dollar Chart 47Widening Trade Deficit Is Dollar Bearish Widening Trade Deficit Is Dollar Bearish Widening Trade Deficit Is Dollar Bearish The US dollar remains pricey relative to its Purchasing Power Parity (PPP) measure of fair value (Chart 48). Speculators are also net long the dollar, making the dollar vulnerable to a positioning reversal (Chart 49). Chart 48The Dollar Is Expensive Based On PPP The Dollar Is Expensive Based On PPP The Dollar Is Expensive Based On PPP Chart 49Long Dollar Is Becoming A Crowded Trade 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Buy The Loonie Our favorite developed market currency going into the fourth quarter is the Canadian dollar. Unlike in most other major economies, Canadian growth has yet to peak. The Bank of Canada has been ahead of most other central banks in winding down QE and laying the groundwork for rate hikes. Chart 50Oil Prices To Remain Firm Oil Prices To Remain Firm Oil Prices To Remain Firm Firm oil prices should also help the loonie. One can be bullish on oil without expecting oil prices to rise very much. The oil curve is heavily backwardated (Chart 50). It suggests that the price of Brent will fall from $79 to $67 per barrel between now and the end of 2023. BCA’s commodity strategists expect the price of Brent crude to average $75 and $80 per barrel in 2022 and 2023, respectively, with WTI trading $2-$4/bbl lower. The RMB Will Hold Its Ground We doubt that China will weaken the RMB in order to stimulate the economy. China’s export sector is already operating at peak capacity. A weaker currency would do little to boost output. Geopolitical concerns will also keep the yuan from depreciating. The trade relationship between China and the US remains frosty. A weaker yuan would only make matters worse. Perhaps more importantly, China wants the RMB to be a global reserve currency. Weakening the RMB would run counter to that goal. A New Supercycle In Metals? China consumes over half the world’s industrial metals. Thus, fluctuations in the Chinese economy tend to drive metals prices. There is a very strong correlation between the Chinese credit impulse and industrial metals prices (Chart 51). If Chinese credit growth picks up over the coming months, this should support metals. Aside from iron ore, it is quite striking that most metals prices have remained firm this year even as China has cut back imports (Chart 52). Copper prices are up 45% year-over-year despite the fact that Chinese imports of copper are down 40% during this period. Chart 51A Pickup In Chinese Credit Will Bode Well For Metals 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Chart 52China Cut Back On Imports Of Commodities This Year China Cut Back On Imports Of Commodities This Year China Cut Back On Imports Of Commodities This Year     As in the early 2000s, the combination of a multi-year period of underinvestment in new mining capacity and new sources of demand could set the stage for an extended bull market in the metals complex. The shift to electric vehicles will boost demand for many metals. The typical electric vehicle uses four times as much copper as a typical gasoline-powered vehicle. Many pundits argue that because Chinese growth is slowing, China will not need as much commodities as in the past. However, this argument ignores the fact that China is slowing from a very high base. As Chart 53 shows, China consumes five times as much industrial metals as it did in the 2000s. In absolute volume terms, China’s incremental annual increase in metal consumption is twice what it was in the 2000s. Thus, Chinese demand is likely to support the commodity market for years to come. Gold Facing Crosswinds Gold prices tend to correlate closely with real interest rates (Chart 54). This is not surprising since the real yield can be regarded as the “opportunity cost” of holding a yield-less asset such as gold. Chart 53Chinese Consumption Of Commodities Ballooned Over The Past Three Decades Chinese Consumption Of Commodities Ballooned Over The Past Three Decades Chinese Consumption Of Commodities Ballooned Over The Past Three Decades Chart 54Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates What is somewhat surprising is that gold prices have dipped more than one would have expected based on the evolution of real yields. The US 10-year TIPS yield is only slightly higher than where it was in early August 2020, when the price of gold reached $2,067 per ounce. Although it is difficult to be certain, the shift in investor interest from gold to cryptos has probably depressed gold prices. Both gold and cryptos are seen as “fiat money hedges”. Our expectation is that tighter regulation will imperil the cryptocurrency market, causing some funds to flow back into gold. Nevertheless, with real yields likely to edge higher over the coming years, the upside for gold prices is limited.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1  The steady-state debt-to-GDP ratio can be expressed as p/(r-g), where r is the interest rate, g is trend GDP growth, and p is the primary (i.e., non-interest) budget balance. Thus, for example, if the government wanted to achieve a stable debt-to-GDP ratio of 50% and r-g is -2%, it would need to run a primary budget deficit of 0.5*0.02=1% of GDP. However, if the government targeted a stable debt-to-GDP ratio of 200%, it could run a primary budget deficit of 2*0.02=4% of GDP. See Box 1 in our February 22, 2019 report for a derivation of this debt sustainability equation. Global Investment Strategy View Matrix 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Special Trade Recommendations 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song Current MacroQuant Model Scores 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song 2021 Fourth Quarter Strategy Outlook: TINA’s Siren Song

HighlightsThe power shortage in China due to depleted coal inventories and low hydro availability will push copper and aluminum inventories lower, as refineries there – which account for roughly one-half of global capacity – are shut to conserve power (Chart of the Week).Given the critical role base metals will play in the decarbonization of the global economy, alternative capacity will have to be incentivized ex-China by higher prices to reduce refining-concentration risk in the future.Unexpectedly low renewable-energy output in the EU and UK following last year's cold winter will keep competition with China for LNG cargoes elevated this winter.  It also highlights the unintended consequences of phasing down fossil-fuel generation without sufficient back-up.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere.  Normal-to-warmer temps cannot be entirely dismissed, however.Increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers.We remain long 1Q22 natgas exposure via call spreads; long commodity index exposure (S&P GSCI and COMT ETF) to benefit from increasing backwardation as inventories of industrial commodities fall; and long the PICK ETF to benefit from expected tightening of base metals markets.FeatureNatgas prices are surging in the wake of China's and Europe's scramble to cover power shortages arising from depleted coal inventories and low hydroelectric generation in the former, and unexpectedly low output from renewables in the latter (Chart 2).1Given all the excitement of record-high gas prices in the EU and surging oil prices earlier this week, it is easy to lose sight of the longer-term implications of these developments for the global decarbonization push. Chart of the WeekBase Metals Refining Concentrated In China La Niña And The Energy Transition La Niña And The Energy Transition   Chart 2Surge In Gas Prices Continues La Niña And The Energy Transition La Niña And The Energy Transition  Global copper inventories have been tightening (Chart 3) along with aluminum balances (Chart 4).2 Power shortages in China- which accounts for ~40% of global refined copper output and more than 50% of refined aluminum - are forcing shutdowns in production by authorities seeking to conserve energy going into winter. In addition, the upcoming Winter Olympics in February likely will keep restrictions on steel mills, base-metals refiners, and smelters in place, so as to keep pollution levels down and skies blue. Chart 3Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper   Chart 4Along With Aluminum Balances... Along With Aluminum Balances... Along With Aluminum Balances...  This will keep prices well supported and force manufacturers to draw on inventories, which will keep forward curves for copper (Chart 5) and aluminum (Chart 6) backwardated. Higher costs for manufactured goods can be expected as well, which will exacerbate the cost-push inflation coming through from clogged global supply chains. This slowdown in global supply chains is largely the result of global aggregate demand improving at a faster rate than supply.3 Chart 5Copper Prices And Backwardation Copper Prices And Backwardation Copper Prices And Backwardation   Chart 6...Will Increase Along With Aluminum ...Will Increase Along With Aluminum ...Will Increase Along With Aluminum  The pressures on base metals markets highlight the supply-concentration risks associated with the large share of global refining capacity located in China. This makes refined base metals supplies and inventories globally subject to whatever dislocations are impacting China at any point in time. As the world embarks on an unprecedented decarbonization effort, this concentration of metals refining capacity becomes increasingly important, given the centrality of base metals in the build-out of renewable-energy and electric-vehicles (EVs) globally (Chart 7).In addition, increasing tension between Western states and China supports arguments to diversify supplies of refined metals in the future (e.g., the US, UK and Australia deal to supply US nuclear-powered submarine technology to Australia, and the tense Sino-Australian trade relationship that led to lower Chinese coal inventories).4 Chart 7The Need For Refined Metals Grows La Niña And The Energy Transition La Niña And The Energy Transition  EU's Renewables Bet SoursUnlike China, which gets ~ 11% of its electricity from renewables and ~ 63% of its power from coal-fired generation (Chart 8), the EU gets ~ 26% of its power from renewables and ~ 13% from coal (Chart 9). In fact, the EU's made a huge bet on renewables, particularly wind power, which accounts for ~55% of its renewables supply. Chart 8China's Dependence On Coal … La Niña And The Energy Transition La Niña And The Energy Transition   Chart 9… Greatly Exceeds The EU's La Niña And The Energy Transition La Niña And The Energy Transition  Unexpectedly low renewable-energy output in the EU and UK this summer – particularly wind power – forced both to scramble for natgas and coal supplies to cover power needs.5 As can be seen in Chart 9, the EU has been winding down its fossil-fuel-fired electric generation in favor of renewables. When the wind stopped blowing this year the EU was forced into an intense competition with China for LNG cargoes in order to provide power and rebuild storage for the coming winter (Chart 10). Chart 10The Scramble For Natgas Continues La Niña And The Energy Transition La Niña And The Energy Transition  The current heated – no pun intended – competition for natgas going into the coming winter is the result of two policy errors, which will be corrected by Spring of next year. On China's side, coal inventories were allowed to run down due to diplomacy, which left inventories short going into winter. In the EU, wind power availability fell far short of expectations, another result of a policy miscalculation: Nameplate wind capacity is meaningless if the wind stops blowing. Likewise for sun on a cloudy day.Natgas Price Run-Up Is TransitoryThe run-up in natgas prices occasioned by China's and the EU's scramble for supplies is transitory. Still, uncertainty as to the ultimate path global gas prices will take is at its maximum level at present.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere. Even so, this is a probabilistic assessment: Normal-to-warmer temps cannot be dismissed, given this probability. A normal to warmer winter would leave US inventories and the availability to increase LNG exports higher, which would alleviate much of the pricing pressure holding Asian and European gas prices at eye-watering levels presently.Going into 1Q22, we expect increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers as hospitalization and death rates continue to fall (Chart 11).6 At that point, we would expect economic activity to pick up significantly, which would be bullish for natgas. We also expect US and Russian natgas production to pick up, with higher prices supporting higher rig counts in the US in particular. Chart 11Expect Continued COVID-19 Progress La Niña And The Energy Transition La Niña And The Energy Transition  Investment ImplicationsAs the world embarks on an unprecedented decarbonization effort, it is important to follow the supply dynamics of base metals, which will provide the materials needed to build out renewable generation and EVs.The current price pressure in natural gas markets resulting from policy miscalculations cannot be ignored. Still, this pressure is more likely to be addressed quickly and effectively than the structural constraints in base metals markets.On the base metals side, producers remain leery of committing to large capex projects at the scale implied by policy projections for the renewables buildout.7In addition, current market conditions highlight concentration risks in these markets – particularly on the refining side in base metals, where much of global capacity resides in China. On the production and refining side of EV materials, battery technology remains massively concentrated to a few countries (e.g., cobalt mining and refining in the Democratic Republic of Congo and China, respectively).This reinforces our view that oil and gas production and consumption likely will not decay sharply unless and until these capex issues and concentration risks are addressed. For this reason, we remain bullish oil and gas. Robert P. Ryan Chief Commodity & Energy Strategistrryan@bcaresearch.comAshwin ShyamResearch AssociateCommodity & Energy Strategyashwin.shyam@bcaresearch.com Commodities Round-UpEnergy: BullishDelegates at OPEC 2.0's Ministerial Meeting on Monday likely will agree to increase the amount of oil being returned to markets by an additional 100-200k b/d. This would take the monthly production rate of production being restored from 400k b/d to 500-600k b/d. Depending on how quickly mRNA vaccine production in large EM markets is rolled out, this incremental increase could remain in place into 2Q22. This would assuage market concerns prices could get to the point that demand is destroyed just as economic re-opening is beginning in EM economies. Our view remains that the producer coalition led by Saudi Arabia and Russia will continue to balance the need for higher revenues of member states with the fragile recovery in EM economies. We continue to expect prices in 2022 to average $75/bbl and $80/bbl in 2023 (Chart 12). This allows OPEC 2.0 states to rebuild their balance sheets and fund their efforts to diversify their economies without triggering demand destruction.Base Metals: BullishA power crunch and decarbonization policies in China are supporting aluminum prices at around 13-year highs, after reaching a multi-year peak earlier this month (Chart 13). The energy-intensive electrolytic process of converting alumina to metal makes aluminum production highly sensitive to fluctuations in power prices. High power prices and electricity shortages are impacting aluminum companies all over China, one of which is Yunnan Aluminium. According to the Financial Times, the company accounts for 10% of total aluminum supply in the world’s largest producer.Precious Metals: BullishGold prices dipped following a hawkish FOMC meeting last week. More Fed officials see a rate hike in 2022, compared to the previous set of projections released in June. Fed Chair Jay Powell also hinted at a taper in the asset purchase program on the back of a rebounding US economy, provided a resurgence in COVID-19 does not interrupt this progress. A confirmation of what markets were expecting – i.e., paring asset purchases by year-end – and possible rate hikes next year have buoyed the US dollar and Treasury yields. The USD competes directly with gold for safe-haven investment demand. Higher interest rates will increase the opportunity cost of holding the yellow metal. As a result, gold prices will be subdued when the USD is strengthening. We remain bearish the USD, and, therefore, bullish gold. Chart 12Oil Forecasts Hold Steady Oil Forecasts Hold Steady Oil Forecasts Hold Steady   Chart 12Aluminum Prices Recovering Aluminum Prices Recovering Aluminum Prices Recovering    Footnotes1     Please see China's Yunnan imposes output curbs on aluminium, steel, cement makers published by reuters.com on September 13, 2021.2     NB: Global aluminum inventory data are unreliable and we do not publish them.3    Please see, e.g., Supply Chains, Global Growth, and Inflation, published by gspublishing.com on September 20, 2021.4    Please see US-China: War Preparation Pushes Commodity Demand, a Special Report we published on August 26, 2021, for further discussion.5    We discuss this in last week's report entitled Natgas Markets Continue To Tighten, which is available at ces.bcaresearch.com.6    Please see Upside Price Risk Rises For Crude, which updated our oil-price balances and forecasts. We highlight the recent agreements to mass produce the highly effective mRNA COVID-19 vaccines globally as bullish for oil prices. It also will be bullish for natgas and other commodities.7     Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021, for additional discussion. Investment Views and ThemesStrategic RecommendationsTactical TradesCommodity Prices and Plays Reference TableTrades Closed in 2021Summary of Closed Trades

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" "Buying Conditions Are Poor" "Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Demand Is On Trend... Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend ...But Employment Is Well Below Trend ...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Tin Is Fragile Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound   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 The global fight against the Delta variant of COVID-19 continued to show progress in the month of September, but not without cost. Growth in services activity slowed meaningfully, which has likely delayed the return to potential output in the US until March of next year (at the earliest). However, even with this revised timeline, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. In this regard, the Fed’s likely decision at its next meeting to taper the rate of its asset purchases makes sense and is consistent with a first rate hike in the second half of 2022. The rise in long-maturity bond yields following this month’s Fed meeting is consistent with the view that 10-year Treasurys are overvalued and that yields will trend higher over the coming year. Fixed-income investors should stay short duration. The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. In our view, a detailed examination of shipping prices over the past 18 months points to a future pace of inflation that is not dangerously above-target, but does meet the Fed’s liftoff criteria. A mix-shift in consumer spending, away from goods and toward services, is not a threat to economic activity or S&P 500 earnings – so long as the decline in the former is not outsized relative to the rise in the latter. It will, however, disproportionately impact China, and could be the trigger for meaningful further easing by Chinese policymakers. In the interim, a catalyst for EM stocks may remain elusive. We continue to recommend an overweight stance toward value versus growth stocks and global ex-US versus the US, particularly in favor of developed markets ex-US. Investors should remain cyclically overweight stocks versus bonds, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months in response to higher long-maturity bond yields. Still, we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Feature The global fight against the Delta variant of COVID-19 continued to show progress in the month of September. Chart I-1 highlights that an estimate of the reproduction rate of the disease in developed economies has fallen below one, and the weekly change in hospitalizations in both the US and UK – the two countries at the epicenter of the Delta wave that have not reintroduced widespread COVID-19 control measures – have fallen back into negative territory. In addition, we estimate that approximately 6% of the world’s population received vaccines against COVID-19 in September, with now 45% of the globe having received a first dose and 33% now fully vaccinated. Pfizer’s announcement last week that it has found a “favorable safety profile and robust neutralizing antibody responses” from its vaccine trial in children five to eleven years of age suggests that the FDA may grant emergency use authorization within weeks, which would likely raise the vaccination rate in the US (and ultimately other advanced economies) by at least 5 percentage points in fairly short order. This would also further reduce the impact of school/classroom closures on the labor market, via both an increased participation rate and increased hiring in the education sector. This fight, however, has not been without cost. US jobs growth slowed significantly in August, manufacturing and services PMIs continued to slow in September, and, as Chart I-2 highlights, the normalization in transportation use that was well underway in the first half of the year has clearly inflected in both the US and UK in response to the spread of Delta. Consensus market expectations for Q3 growth have been cut in the US, and to a lesser extent in the euro area, and the Fed reduced its forecast for 2021 real GDP growth from 7% to 5.9% following the September FOMC meeting. Chart I-1The Delta Wave Continues To Abate... The Delta Wave Continues To Abate... The Delta Wave Continues To Abate... Chart I-2...But At A Cost To Economic Activity ...But At A Cost To Economic Activity ...But At A Cost To Economic Activity   The Path Toward Eventually Tighter Monetary Policy It has been surprising to some investors that the Fed has moved forward with their plans to taper the rate of its asset purchases against this backdrop of slowing near-term growth – an event that now seems likely to occur at its next meeting barring a disastrous September payroll report. In our view, this is not especially surprising, given that the Fed has expressed a desire for net purchases to reach zero before they raise interest rates for the first time. Chair Powell noted during last week’s press conference that FOMC participants felt a “gradual tapering process that concludes around the middle of next year is likely to be appropriate”, underscoring that the Fed wants the flexibility to raise interest rates in the second half of next year. The timing of the first Fed rate hike is entirely subject to the evolution of the economic data over the next year, and is not, in any way, calendar-based. But we presented in last month's Special Report why the Fed’s maximum employment criteria may be met as early as next summer,1 and the Fed’s projections for the pace of tapering are consistent with our analysis. Chart I-3Maximum Employment Remains A Very Possible Outcome By Next Summer Maximum Employment Remains A Very Possible Outcome By Next Summer Maximum Employment Remains A Very Possible Outcome By Next Summer The Fed’s most recent Summary of Economic Projections (“SEP”) also seemingly confirmed Fed Vice Chair Richard Clarida’s view that a 3.8% unemployment rate is consistent with maximum employment, barring any issues with the “breadth and inclusivity” of the labor market recovery. We noted in last month’s report that these issues are unlikely in a scenario where jobs growth is sufficiently high to bring down the unemployment rate below 4%. Chart I-3 highlights that both the Fed’s forecast and Bloomberg consensus expectations imply a closed output gap by March, even after factoring in the near-term impact of the Delta variant. Consequently, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. Long-maturity bond yields rose following the Fed meeting, which is also not especially surprising given how low yields have fallen relative to the fair value implied by the Fed’s SEP forecasts even assuming a December 2022 initial rate hike. Chart I-4 highlights that the fair value of the 10-year Treasury yield today is roughly 2% using this approach, rising to 2.15% by next summer. Ironically, the September SEP update modestly lowered the fair value shown in Chart I-4 relative to what would otherwise have been the case, as it implied that the Fed is expecting to raise interest rates at a pace of approximately three hikes per year – rather than the four that prevailed prior to the pandemic. Investors should also note that the fair value for the 10-year yield is nontrivially lower based on market participant and primary dealer estimates of the terminal Fed funds rate (also shown in Chart I-4), although they still imply that long-maturity yields should trend higher over the coming year. Global Trade, Inflation, And The Fed A return to maximum employment will likely signal the onset of monetary policy tightening, as long as the Fed's inflation criteria for liftoff have been met. For now, inflation is signaling a green light for hikes next year, even after excluding the prices of COVID-impacted services and cars (Chart I-5). In fact, more recently, CPI ex-direct COVID effects has been pointing in the “non-transitory” direction, which continues to prompt questions from investors about whether the Fed will be forced to hike earlier than it currently expects for reasons other than a return to maximum employment. Chart I-4US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year Chart I-5For Now, Inflation Is Signaling A Green Light For Hikes Next Year For Now, Inflation Is Signaling A Green Light For Hikes Next Year For Now, Inflation Is Signaling A Green Light For Hikes Next Year   At least some portion of the current pace of increase in consumer goods prices is tied to surging import costs, which have run well in-excess of what would be predicted by the relationship with the US dollar (Chart I-6). This, in turn, is being driven by an explosion in shipping costs that has occurred since the onset of the pandemic, which is being driven both by demand and supply-side factors (Chart I-7). Chart I-6US CPI Is Being Affected By Surging Import Prices... US CPI Is Being Affected By Surging Import Prices... US CPI Is Being Affected By Surging Import Prices... Chart I-7...Which Are Being Driven By An Explosion In Shipping Costs ...Which Are Being Driven By An Explosion In Shipping Costs ...Which Are Being Driven By An Explosion In Shipping Costs   The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. To the extent that demand side factors are mostly responsible, investors should have higher confidence that the recent surge in consumer prices is transitory, because a shift away from above-trend goods spending and toward below-trend services spending is likely over the coming year. If supply-side factors are mostly responsible, then it is conceivable that the global supply chain impact on consumer goods prices will persist for longer than would otherwise be the case, potentially raising the odds of a larger or more sustained rise in inflation expectations. In our view, a detailed examination of shipping prices over the past 18 months points to a mix of both demand and supply effects, even since the beginning of 2021. However, as we highlight below, several facts point toward the view that supply-side factors will be the dominant driver over the coming year, and that they are more likely to exert a disinflationary/deflationary rather than inflationary effect: Chart I-8 breaks down the cumulative change in the overall Freightos Baltic Index by route since December 2019. The chart makes it clear that shipping costs from China/East Asia to the West Coast of the US have risen far more than any other route, underscoring that US demand for goods has been an important part of the rise in shipping costs. Chart I-8US Demand For Goods Is An Important Part Of The Shipping Cost Story October 2021 October 2021 Chart I-9US Goods Spending Has Clearly Been Boosted By US Fiscal Policy US Goods Spending Has Clearly Been Boosted By US Fiscal Policy US Goods Spending Has Clearly Been Boosted By US Fiscal Policy Chart I-9 shows the level of real US personal consumption expenditures on goods relative to its pre-pandemic trendline, underscoring both that goods spending is currently well-above trend, and that there have been two distinct phases of rising goods spending: from May to October 2020 following the passage of the CARES act, and from January to March 2021 following the December 2020 extension of UI benefits and in anticipation of the passage of the American Rescue Plan. Since March, US real goods spending has trended lower, a pattern that we expect will continue over the coming year. Chart I-10 highlights that while the global supply chain struggled heavily last year in response to surging demand and the lagging effects of labor shortages and factory shutdowns during the earliest phase of the pandemic, there were some signs of supply-side normalization in the first half of 2021. The chart highlights that the number of ships at anchor at the Los Angeles and Long Beach ports declined meaningfully from February to June, and global shipping schedule reliability tentatively improved in March. The chart also shows that shipping costs from China/East Asia to the West Coast of the US continued to rise in Q2 seemingly as a lagged response to the Jan-Mar rise in goods spending, but they were still low at the end of June compared to today’s levels. Chart I-10Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs In Q3, circumstances drastically changed. Shipping costs between China/East Asia to the West Coast of the US rapidly doubled, and the number of ships at anchor at the LA/LB ports exploded well past its peak in early February. This rise in China/US shipping costs since late-June has accounted for nearly 60% of the cumulative rise since the pandemic began, and cannot be attributed to increased demand. Instead, the increase in prices and the surge in port congestion in Q3 appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Yantian is the fourth largest port in the world and exports a sizeable majority of global electronics given its close proximity to Shenzhen, underscoring the impact that its closure likely had on an already bottlenecked logistical system. There are two key points emanating from our analysis of global shipping costs. First, demand has been an important effect driving costs higher, but it does not appear to have driven most of the increase in shipping costs this year. Still, over the coming year, goods demand in advanced economies is likely to wane as consumer spending shifts from goods to services spending, which will help ease clogged global trade channels and lower shipping costs. Second, the (brief) evidence of supply-side normalization in the first half of 2021, when consumer demand was actually strengthening, suggests that the supply-side of the global trade system will turn disinflationary over the coming year if further COVID-related labor market shocks can be avoided. What does this mean for the Fed and the prospect of monetary policy tightening next year? In our view, the combination of a positive output gap, stable but normalized inflation expectations, and disinflation (or outright deflation) in COVID-related goods and services (including import prices) is likely to lead to a pace of inflation that meets the Fed’s liftoff criteria. Chart I-11 highlights that important longer-term inflation expectations measures have recently been well-behaved, despite a surge in actual inflation and shorter-term expectations for inflation. Aided by disinflation/deflation in certain high-profile COVID-related goods and services prices, this argues against meaningful upside risks to inflation. However, the current level of long-term expectations and the fact that the output gap is set to turn positive in the first half of next year argues against the notion that inflation will fall below target outside of COVID-related effects. As such, we continue to expect that the Fed will raise interest rates next year, potentially as early as next summer, driven by the progress towards maximum employment. Spending Shifts And The Equity Market We noted above, and in previous reports, that consumer spending in advanced economies is likely to continue to shift away from goods and toward services over the coming year. This raises the question of whether a contraction in goods spending will weigh disproportionately on the economy and equity earnings, given the close historical correlation between manufacturing activity and the business cycle. Chart I-12 illustrates this risk: in a hypothetical scenario in which real goods spending were to return to the trendline shown in Chart I-9 by March of next year, it would contract on the order of 10% on a year-over-year basis, on par with what occurred last year and vastly in excess of what even normally occurs during a recession. Chart I-11Longer-Term Inflation Expectations Remain Well-Behaved Longer-Term Inflation Expectations Remain Well-Behaved Longer-Term Inflation Expectations Remain Well-Behaved Chart I-12A Contraction In Goods Spending Is Likely Over The Coming Year A Contraction In Goods Spending Is Likely Over The Coming Year A Contraction In Goods Spending Is Likely Over The Coming Year   Chart I-12 is a hypothetical scenario and not a forecast, as there is some evidence that consumers are currently deferring durable goods purchases on the expectation that prices will become more favorable. In addition, a positive output gap next year implies that goods spending may settle above its pre-pandemic trendline. Nevertheless, the prospect of a potentially significant slowdown in goods spending has unnerved some investors, even given the prospect of improved services spending. Chart I-13highlights that this fear is understandable given how the US economy normally behaves. The top panel of the chart shows the year-over-year contribution to real GDP growth from real goods and services spending, and the bottom panel shows these contributions in absolute terms to better illustrate their relative magnitudes. The chart makes it clear that goods spending is normally a more forceful driver of economic activity than is the case for services spending, which ostensibly supports concerns that a significant slowdown in the former may be destabilizing for overall activity. Chart I-13Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. However, Chart I-13 also highlights that the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-WWII economic environment. This is not surprising given the nature of the COVID-19 pandemic, but it is important because it underscores that investors should not rely excessively on typical rules of thumb about how modern economies tend to function over the course of the business cycle. In terms of the impact on overall economic activity, investors should focus on the net impact of goods plus services spending. It is certainly possible that the former will slow at a pace that is not fully compensated by the latter, but our sense is that this is not likely to occur barring a further extension of the pandemic in advanced economies. Chart I-14Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Chart I-14 presents a similar conclusion for the US equity market. The chart highlights the historical five-year correlation between the quarterly growth of nominal spending and S&P 500 sales per share. The chart shows that S&P 500 revenue was more sensitive to goods versus services spending prior to the 1990s, when the US was more manufacturing-oriented and goods were more likely to be produced domestically than is the case today. Another gap in the correlation emerged following the global financial crisis when the US household sector underwent several years of deleveraging. But over the past five years, Chart I-14 highlights that S&P 500 revenue growth has actually been more strongly correlated with US services spending than goods spending. Some of this increased correlation might reflect technology-related services spending which could suffer in a post-pandemic environment, but the bottom line from Chart I-14 is that there is not much empirical support for the view that US equity fundamentals will be disproportionately impacted by a slowdown in goods spending, so long as services spending rises in lockstep. China: Exacerbating An Underlying Trend Chart I-15China Will Be Disproportionately Affected By Slowing DM Goods Spending China Will Be Disproportionately Affected By Slowing DM Goods Spending China Will Be Disproportionately Affected By Slowing DM Goods Spending China, on the other hand, will be disproportionately affected by slower goods spending in advanced economies, because its exports have disproportionately benefited from the surge in spending on goods over the past year. Chart I-15 highlights that Chinese export volume growth has exploded this year, and that current export growth is running at a pace of 10% in volume terms – significantly higher than has been the case on average over the past decade. Several problems in China have been in the headlines over the past few months: a regulatory crackdown by Chinese authorities on new economy companies, the situation with Evergrande and, more recently, power shortages that have forced factories in several key manufacturing hubs to curtail production as a result of China’s ban on coal imports from Australia (Chart I-16). However, the key point for investors is that these are not truly new risks to China’s growth outlook; rather, they are developments that have the potential to magnify the impact of an already established trend: the ongoing slowdown in China’s economy that has clearly been caused by a decline in its credit impulse (Chart I-17). In turn, China’s decelerating credit impulse has been caused by tighter regulatory and monetary policy. Chart I-16Power Outages: The Latest Negative Headline From China Power Outages: The Latest Negative Headline From China Power Outages: The Latest Negative Headline From China Chart I-17China Is Slowing Because Policymakers Have Tightened China Is Slowing Because Policymakers Have Tightened China Is Slowing Because Policymakers Have Tightened   BCA’s China Investment Strategy service has provided a detailed analysis of the ongoing Evergrande saga.2 In short, our view is that the government will likely restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. As such, Beijing may rescue the stakeholders of Evergrande, but likely not its shareholders. However, in terms of stimulating the broader economy, it is still not clear that Chinese policymakers are willing to engage in more than gradual or piecemeal stimulus, given a higher pain threshold for a slower economy and a lower appetite for leverage. This may change once Chinese export growth slows in response to a shift in DM spending from goods to services, as policymakers will no longer be able to rely on the external sector for support. This potentially offsetting nature of eventual Chinese stimulus and global goods spending underscores both the importance of a normalization in DM services spending as an impulse for global growth, as well as the fact that a catalyst for EM stocks may remain elusive over the tactical horizon. Investment Conclusions In Section 2 of this month’s report, we explain why the performance of US stocks may be flat versus their global peers over a structural time horizon. We also highlighted that US stocks are likely to earn low annualized total returns over the coming 10 years (between 1.8 - 4.7%), which would fall well short of the absolute return goals of many investors. Chart I-18Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Over the coming 6-12 month time horizon, we continue to recommend an overweight stance towards value vs. growth stocks and global ex-US vs. US, particularly in favor of developed markets ex-US. The relative performance of value vs. growth stocks is likely to benefit from the transition to a post-pandemic state and a rise in long-maturity bond yields, as monetary policy shifts towards the point of tightening. Regional equity trends have been closely correlated with style over the past two years, and the underperformance of growth strongly implies US equity underperformance. From an asset allocation perspective, investors should remain overweight stocks versus bonds over the coming year, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months. Chart I-18 highlights that outside of the context of recessions, months with negative returns from both stocks and long-maturity bonds are quite rare, but they tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). Fundamentally, we do not see a rise in bond yields to any of the levels shown in Chart I-4 as being threatening to economic growth or necessarily implying lower equity market multiples. But the speed of adjustment in bond yields could unnerve equity investors, and there are open questions as to how far the equity risk premium can fall before T.I.N.A. – “There Is No Alternative” – becomes a less persuasive argument. As such, we would not rule out a brief correction in stocks at some point over the coming several months, but we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst September 30, 2021 Next Report: October 28, 2021 II. The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms Since 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance. There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon. In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples. Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US. The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities. In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar. We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. A Deep Examination Of US Outperformance Since 2008 Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are: Total revenue growth for each equity market, in local currency terms The change in profit margins The impact of changes in capital structure and index composition The change in the trailing P/E ratio The income return from dividends The impact of changes in foreign exchange The sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth October 2021 October 2021 Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends. Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects. Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar October 2021 October 2021 Box II-1 Proxying The Impact Of Changes In Shares Outstanding We proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects. However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It October 2021 October 2021 Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period. What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based October 2021 October 2021 The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services. Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion. Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks October 2021 October 2021 Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… There Has Been A Strong Style Dimension... There Has Been A Strong Style Dimension... Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally. The Relative Secular Return Outlook For US Stocks We present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis. Profit Margins Chart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real October 2021 October 2021 Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.3 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation. But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.” On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors. Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems. In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive). Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models October 2021 October 2021 Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize. Capital Structure And Index Composition As noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments. However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates. Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks? Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years. Equity Multiples There are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close. Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated The Foreign Exchange Effect As a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance. The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance... Chart II-18…And Is Now Expensive October 2021 October 2021   The Absolute Secular Return Outlook For US Stocks Over a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall. For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… October 2021 October 2021 Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%. One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium. In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields. This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.4 In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade October 2021 October 2021 Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US. Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era. Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. 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 technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum as net revisions and positive earnings surprises remain near record highs. Bottom-up analyst earning expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury yield has broken above its 200-day moving average, beginning its recovery after falling sharply since mid-March. After a decline initially caused by waning growth momentum and the impact of the Delta variant of SARS-COV-2, long-maturity bond yields appear to be responding to the interest rate guidance that the Fed has been providing. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that 10-Year Yields are set to trend higher over the coming year. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the pace of advance in industrial metals prices has eased. Global shipping costs have exploded due to supply-side constraints, but are likely to ease over the coming year if further COVID-related labor market shocks can be avoided. US and global LEIs remain very elevated but have started to roll over. 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 is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. 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 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 "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 2  Please see China Investment Strategy "A Quick Take On Embattled Evergrande," dated September 21, 2021, and China Investment Strategy "The Evergrande Saga Continues," dated September 29, 2021, available at cis.bcaresearch.com 3 Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com 4     Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

Dear Client, I will be holding a webcast next Friday, September 24th at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT) with BCA Research’s Chief Emerging Markets Strategist Arthur Budaghyan where we will debate the outlook for EM stocks. As this week’s report conveys, I am bullish, while Arthur is in the bearish camp. Please join us for what is sure to be a fiery debate. Also, instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the stability of the American political system. I hope you will find it insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2021 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, October 7th. Best regards, Peter Berezin Chief Global Strategist Highlights After lagging the global indices, EM stocks are set to outperform during the remainder of this year and into 2022. Go long the EM FTSE index versus the global benchmark (ETF proxy: VWO versus VT). Five factors will support EM assets over the coming months: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Investors wanting to gain exposure to Chinese tech while still limiting risk should consider writing cash-covered puts. For example, a strategy of selling puts on Alibaba could generate a 9% annualized yield while giving investors access to the stock at a forward PE ratio of only 12.5. Go long an equally-weighted basket consisting of the Russian ruble and Brazilian real against the US dollar. Both currencies enjoy favorable interest rate differentials and will benefit from continued strength in commodity markets. Debating The EM Outlook BCA Research has some of the brightest, most creative strategists in the world. While we often agree on many issues, we sometimes disagree. The near-term outlook for emerging markets is a case in point. My colleague, Chief EM Strategist Arthur Budaghyan, is bearish on emerging markets over a 3-to-6 month horizon. In contrast, I am bullish. In this note, I explain why. I see five reasons why EM assets will do very well during the remainder of the year and into 2022: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Let’s examine all five reasons in turn. Vaccine Access In Emerging Markets Is Improving The proportion of EM populations which have been vaccinated is rising rapidly (Chart 1). India is now vaccinating 10 million people per day, a number that would have seemed unimaginable just a few months ago. Chart 1EM Vaccination Rates Have Been Ramping Up Rapidly The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Globally, about 10 billion doses of vaccine will be produced this year (Chart 2). This does not include potential new mRNA vaccines that China is developing. China-based Walvax Biotechnology is conducting late-stage trials in Nepal, with mass production of the vaccine expected to start in October. Sinopharm is also working on its own mRNA vaccine. Meanwhile, the number of new Covid cases in most EM economies has peaked, permitting a relaxation of lockdown measures (Chart 3). Goldman’s Effective Lockdown Index for China has eased significantly since mid-August, although this week’s outbreak in Fujian province could partially reverse that trend. Chart 2At Least 10 Billion Doses Of Vaccine Will Be Produced This Year The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 3EM Lockdown Measures Have Eased As The Number Of New Cases Has Peaked The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies It is true, as Arthur has pointed out, that vaccine hesitancy is a problem in some emerging markets. However, this may not be as significant an issue as previously believed. The huge spike in cases in highly vaccinated countries such as Israel and the UK shows that herd immunity is a pipe dream. Given this reality, as long as everyone who wants a vaccine is able to receive it, the political pressure to maintain lockdowns will dissipate. Pandemic-Induced Spike In Inflation Is Fading As in most developed economies, many emerging markets have experienced a post-pandemic rise in inflation (Chart 4). Whereas DM central banks generally looked through the inflation spike, many EMs did not have that luxury. Chart 4Inflation Across The EM Universe The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies   Worried about an unmooring of inflation expectations and currency depreciation, central banks in such countries as Brazil, Mexico, Chile, Colombia, Peru, Russia, and Turkey have all raised rates this year. Higher rates have weighed on EM growth and financial markets. The good news is that inflationary pressures are starting to abate. This week’s US CPI report for August showed an absolute decline in prices in pandemic-related categories such as airfares, hotels, admissions, and vehicles (Chart 5). Things are even improving on the semiconductor front. Chart 6 shows that memory chip prices are in a clear downtrend. Chart 5Pandemic-Driven Inflation Is Cresting The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 6Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chip Prices Are Off Their Highs Chart 7Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Critically for emerging markets, agricultural prices have stabilized (Chart 7). Historically, food inflation has been a major driver of EM inflation. Chinese Stimulus On The Way Growth in China was quite weak in the first half of the year, averaging only 3.5% on a sequential annualized basis (Chart 8). The Bloomberg consensus estimate is for Q3 growth to hit 4.3%, reflecting the negative impact of lockdown measures and the lagged effect from policy tightening. Growth in the fourth quarter is expected to rebound to only 5.7%. This seems too low to us. Barring a major spike in Covid cases, Chinese industry will be saddled with fewer social distancing restrictions in the fourth quarter. Policy is also turning more stimulative. The PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 9). Chart 8Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chart 9Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way Chinese Stimulus Is On The Way   With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. On the contrary, the PBOC’s meeting with financial institutions on August 23rd revealed a desire to increase credit availability. Partly reflecting this development, new bank loans rose to RMB 1.22 trillion in August, up from RMB 1.08 trillion in the prior month. Chart 10EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed On the fiscal side, the Ministry of Finance stated on August 27th its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. To reinforce the need for more stimulus, the authorities announced an additional RMB 300 billion in credit support for SMEs during the latest State Council meeting held on September 1st. Local Chinese government spending has typically flowed into infrastructure. Increased infrastructure spending should buttress metals prices while providing a tailwind for global industrial stocks. I agree with Arthur’s assessment that industrials will be a winning equity sector over the coming years. EM stocks have usually beaten the global benchmark during periods when global industrial stocks were outperforming (Chart 10).   A Weaker US Dollar Will Benefit Emerging Markets EM stocks tend to perform best when the US dollar is on the back foot (Chart 11). We expect the greenback to weaken over the next 12 months. As a countercyclical currency, the dollar is likely to struggle in an environment of above-trend global growth (Chart 12). Chart 11EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening Chart 12The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Interest rate differentials have moved sharply against the dollar (Chart 13). The US trade deficit has surged over the past 16 months. The way the US has been financing its trade deficit – relying heavily on fickle equity inflows – also leaves the dollar in a vulnerable position (Chart 14). Chart 13Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Chart 14Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Go Long BRL And RUB Against a backdrop of broad-based dollar weakness, EM currencies will strengthen. Currently, the 12-month interest rate differential between Brazil and the US stands at 8.7%, up from a low of 2.1% last year. Russian rates have also risen rapidly relative to US rates (Chart 15). The Russian ruble will benefit from the cyclical recovery in oil prices. Bob Ryan and BCA’s commodity team project that the price of Brent will rise 5% to $80/bbl in 2023, whereas market expectations are for a 12% decline (Chart 16). Likewise, Brazil will gain from both higher oil prices and rising Chinese demand for metals. Chart 15Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Interest Rate Differentials Favor The RUB And BRL Versus The USD Chart 16Oil Prices Have More Upside Oil Prices Have More Upside Oil Prices Have More Upside Accordingly, we are initiating a new trade going long an equally-weighted basket consisting of BRL/USD and RUB/USD. Are EMs A Value Trap? Emerging market stocks currently trade at a Shiller PE ratio of 14.7, compared to 36.8 for the US, 22.2 for Europe, and 24.1 for Japan. The EM discount to the global index is as large now as it was during the late 1990s. Other valuation measures tell a similar story (Chart 17). Chart 17AEM Equities Are Trading At A Large Discount (I) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Chart 17BEM Equities Are Trading At A Large Discount (II) The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies A low PE ratio for EM stocks could be justified based on weak expected earnings growth. However, it is far from clear that such an expectation is warranted. While EM earnings growth has lagged the US since 2011, this follows a decade when EM earnings grew much faster than in the US (Chart 18). Chart 18AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) Chart 18BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) EM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) Chart 19EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings On that note, it is worth mentioning that US earnings have risen by only 6 percentage points more than EM earnings since mid 2019 (20% versus 14%), even as EM stocks have underperformed their US peers by 29% over this period (52% versus 23%) (Chart 19). China’s Regulatory Crackdown The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 48% since February (Chart 20). Chart 20Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party just as US companies have pledged allegiance to woke ideology. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 16.4-times earnings, Baidu is trading at 17.9-times earnings, and Tencent is trading at 26.7-times current year earnings. In comparison, the NASDAQ 100 trades at nearly 30-times earnings. Investment Conclusions Sentiment towards EM stocks is very bearish (Chart 21). Investor angst towards China is especially elevated, with the media replete with stories about the tech crackdown and problems at Evergrande, the country’s largest property developer. Chart 21Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish Sentiment Towards EM Stocks Is Highly Bearish All these downside risks to EM assets are well known. What are less well known are the upside risks stemming from higher vaccination rates, an easing of domestic inflationary pressures, Chinese stimulus, a weaker US dollar, and favorable valuations. With that in mind, we are upgrading our rating on EM equities and currencies to strong overweight in the view matrix at the back of this report. We are also reinstating a long EM/Global equity trade (ETF proxy: VWO versus VT). The risk-reward of buying Chinese internet stocks is reasonably appealing. Investors who want to mitigate risk should consider writing cash-covered puts. For example, a BABA put with a strike price of $130 expiring on December 16th 2022 trades for about $16. If the price of BABA does not fall below $130, you will pocket the premium, realizing an annualized yield of 9%. If the price does fall to $130, you get the stock at an attractive PE ratio of 12.5 based on current forward earnings estimates.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Special Trade Recommendations The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies Current MacroQuant Model Scores The Best Trade For The Rest Of 2021: Long EM Equities And Currencies The Best Trade For The Rest Of 2021: Long EM Equities And Currencies

Highlights The odds of a stronger recovery in EM oil demand next year are rising, as vaccines using mRNA technology are manufactured locally and become widely available.1 This will reduce local lock-down risks in economies relying on less efficacious COVID-19 vaccines – or lacking them altogether – thereby increasing mobility, economic activity and oil demand. Our global crude oil balances estimates are little changed to the end of 2023, which leaves our price expectations mostly unchanged: 4Q21 Brent prices are expected to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively (Chart of the Week). The balance of risks to the crude oil market remain to the upside in our estimation. In addition to a higher likelihood of better-than-expected EM demand growth, we expect OPEC 2.0 production discipline to hold, and for the price-taking cohort outside the coalition to continue prioritizing investors' interests. We remain long commodity index exposure – S&P GSCI and COMT – and, at tonight's close, will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE) on the back of increasing local mRNA vaccine production in EM economies. Feature As local production of COVID-19 vaccines employing mRNA technology spreads throughout EM economies, the odds of a stronger-than-expected recovery in oil demand next year will increase. The buildout of production and distribution facilities for this technology is progressing quickly in Asia – e.g., Chinese mRNA tech joint ventures are expected to be in production mode in 4Q21 – Latin America, Africa, and the Middle East.2 Accelerated availability of more efficacious vaccines globally will address the "fault lines" identified by the IMF in its July 2021 update. In that report, the Fund notes a major downside risk to its global GDP growth expectation of 6% this year remains slower-than-expected vaccine rollouts to emerging and developing economies.3 The other major risk identified by the Fund is too-rapid a winddown of policy support in DM economies, which would lead to tighter financial conditions globally. Our global demand expectation is driven by GDP estimates from the IMF and World Bank. The implication of that assumption is the powerful recovery in DM oil demand seen this year will slow while EM demand picks up next year (Chart 2). We proxy DM oil demand with OECD oil consumption and EM demand with non-OECD consumption. We continue to expect overall oil demand to recover by just over 5.0mm b/d this year and 4.4mm b/d next year (Table 1). Chart of the WeekOil Forecasts Hold Steady Oil Forecasts Hold Steady Oil Forecasts Hold Steady Chart 2Higher EM Oil Demand Expected in 2022 Higher EM Oil Demand Expected in 2022 Higher EM Oil Demand Expected in 2022 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Upside Price Risk Rises For Crude Upside Price Risk Rises For Crude Global Oil Supply To Remain Steady Hurricane Ida will have removed ~ 30mm barrels of US offshore oil output by the time losses are fully tallied, based on IEA estimates. Even so, in line with the US EIA, we expect offshore US oil production will recover from the damage caused by the storm in 4Q21 and be back at ~ 1.7mm b/d on average over the quarter. This will allow oil prices to ease slightly from current elevated levels over the balance of the year. Inland, US shale-oil output remains on track to average ~ 9.06mm b/d this year, 9.55mmb/d in 2022 and 9.85mmb/d in 2023, in our modeling (Chart 3). We expect production in the Lower 48 states of the US to remain mostly steady going forward. Production from finishing drilled-but-uncompleted (DUCs) shale-oil wells is the lowest it's been since 2013.  Output from these wells will remain relatively low for the rest of the year. This supply was developed during the COVID-19 pandemic, as it was cheaper to bring on than new drilling. For 2022 and 2023 overall, our model points to a slow build-up in US shale-oil output as drilling increases. Going into 2022, we expect continued production discipline from OPEC 2.0, and for the coalition to continue to manage output in line with actual demand it sees from its customers. The 400k b/d being returned monthly to the market over August 2021 to mid-2022 will accommodate demand increases. However, it will be monitored closely in the event demand fails to materialize, as has been OPEC 2.0's wont over the course of the pandemic. Chart 3US Shale-Oil Output Mostly Stable US Shale-Oil Output Mostly Stable US Shale-Oil Output Mostly Stable Oil Markets To Remain Balanced We see markets remaining balanced to the end of 2023, with OPEC 2.0 maintaining its production-management strategy – keeping the level of supply just below the level of demand – and the price-taking cohort led by US shale-oil producers remaining focused on maintaining margins so as to provide competitive returns to investors. On the demand side, EM growth will pick up as DM growth slows. Given our fundamental view, global crude oil balances estimates are little changed to the end of 2023 (Chart 4). This allows inventories to continue to draw this year and next, then to slowly rebuild as production increases toward the end of 2023 (Chart 5). Falling inventories will keep the Brent forward curve backwardated – i.e., prompt-delivery oil will trade higher than deferred-delivery oil. Chart 4Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 5...And Oil Inventory Continues To Draw ...And Oil Inventory Continues To Draw ...And Oil Inventory Continues To Draw The backwardated forward curve means OPEC 2.0 producers will continue to realize higher delivered prices on their crude oil than the marginal shale-oil producer, which hedges its production 1-2 years forward to stabilize revenue. This is the primary benefit to the member states in the producer coalition: a backwardated curve pricing closer to marginal cost limits the amount of revenue available to shale-oil producers, and thus restrains output to that which is profitable at the margin. Investment Implications Our supply-demand outlook keeps our price expectations mostly unchanged from last month's forecast. We expect 4Q21 Brent prices to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively, as can be seen in the Chart of the Week. WTI prices will continue to trade $2-$4/bbl below Brent over this interval. With fundamentals continuing to support a backwardated forward curve in Brent and WTI, we continue to favor long commodity-index exposure, which benefits from this structure.4 Therefore, we remain long the S&P GSCI and the COMT ETF, which is an optimized version of the GSCI that concentrates on positioning in backwardated futures contracts. The upside risk to oil prices resulting from increasing local production of mRNA vaccines in EM economies that had relied on less efficacious vaccines undoubtedly will increase mobility and raise oil demand, if, as appears likely, the impact of this localization is realized in the near term. This also could boost commodity demand generally, if it allows trade and GDP growth to accelerate in EM economies, which supports our long commodity-index view. The rollout of mRNA technology into EM economies also suggests EM GDP growth could increase at the margin with locally produced mRNA vaccines becoming more available. This would redound to the benefit of trade and economic activity generally.5 It also could help unsnarl the movement of goods globally. The wider implications of a successful expansion of locally produced mRNA vaccines leads us to recommend EM equity exposure on a tactical basis. At tonight's close, we will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE). As this is tactical, we will use a tight stop (10%) for this recommendation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Natural gas demand is surging globally. Record-breaking heat waves in the US are driving demand for gas-fired generation required to meet space-cooling demand. In addition, in the June-August period, the US saw record LNG exports. Europe and Asia are competing for the fuel as both prepare for winter. Brazil also has been a strong bid for LNG, as drought there has reduced hydropower supplies. In Europe, natural gas inventories were drawn hard this past winter as LNG supplies were bid away to Asia to meet space-heating demand. This is keeping Europe well bid now as winter approaches (Chart 6). The US Climate Prediction Center last week gave 70-80% odds of a second La Niña for the Northern Hemisphere winter. Should it materialize, it could again drive cold artic air into their markets, as it did last winter, and push natgas demand higher. Our recommendation to get long 1Q22 $5.00/MMBtu calls vs short 1Q22 $5.50/MMBtu calls last week was up 17% as of Tuesday's close. We remain long. Base Metals: Bullish The slide in iron ore prices from its ~ $230/MT peak earlier this year can be attributed to weak Chinese demand, and the possibility of its persistence through the winter and into next year (Chart 7). The world’s largest steel-producing nation is aiming to limit steel output to no higher than 2020 levels, in a bid to reduce industrial pollution. According to mining.com, provincial governments have directly asked local steel mills to curb output. Regulation in this sector in China will continue to reduce prices of iron ore, a key raw material in steel production. Precious Metals: Bullish The lower-than-expected reading on the US core CPI earlier this week weighed on the USD, and propelled gold prices above the $1,800/oz mark. While markets expected lower consumer prices for August to diminish the Fed’s resolve to taper asset purchases by year-end, we do not think the lower month-on-month CPI number will delay tapering. The timing of the Fed's initial rate hike – expected by markets to occur after the tapering of the central bank's asset-purchase program – will depend on the US labor force reaching "maximum employment." According to BCA Research's US Bond Strategy, this criterion will be met in late-2022 or early-2023. Low-interest rates, coupled with persistent inflation until then, will be bullish for gold prices. Chart 6 Upside Price Risk Rises For Crude Upside Price Risk Rises For Crude Chart 7 CHINA IMPORTED IRON ORE GOING DOWN CHINA IMPORTED IRON ORE GOING DOWN   Footnotes 1     Please see Everest to bring Canadian biotech's potential Covid shots to China, other markets published on September 13, 2021 by indiatimes.com. 2     Examples of this include Brazil's Eurofarma to make Pfizer COVID-19 shots for Latin America, published by reuters.com; Biovac Institute to be first African company to produce mRNA vaccines, published be devex.com; and mRNA Vaccines Mark a New Era in Medicine, posted by supertrends.com. The latter report also discusses the application of mRNA technology to other diseases like malaria. 3    Please see Fault Lines Widen in the Global Recovery published 27 July 2021 by the Fund. 4    Backwardation is the source of roll yield for long-index exposure.  This is due to the design of these index products, which buy forward then – in backwardated markets – roll out of futures contract as they approach physical delivery at a higher level and re-establish their exposure in a deferred contract. 5    The lower realized efficacy of Sinopharm and Sinovac COVID-19 vaccines and high reinfection rates in economies using these vaccines are one of the key risks to our overall bullish commodity view.  Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Canada has been a G10 leader in innoculating its population. This should allow economic activity to resume, boosting the CAD/USD. A cresting in COVID-19 infections should permit the Bank of Canada to reintroduce a hawkish bias in upcoming policy meetings. While the CAD/USD is likely to strengthen, it will underperform at the crosses. Feature The Canadian dollar has been rather resilient amid broad US dollar strength this year. While the DXY is up 2.8%, the loonie has still managed to outperform marginally. This is a remarkable feat, given that the Canadian dollar is very much a procyclical currency, and is usually held hostage by broad movements in the trade-weighted dollar. The vaccination campaign in Canada has been very successful, pinning the country as a leader in the G10. This has partly helped curtail the number of new infections from the Delta variant of COVID-19, allowing the economy to reopen faster than its peers (Chart I-1). This is important because there has been a very clear correlation between currency markets and vaccination rates. In general, the countries with higher vaccination rates (UK, Canada, US) have seen better currency performance than countries with the worst vaccination rates (Australia, Japan, Chart I-2). Chart I-1Vaccinations Have Worked For Canada Vaccinations Have Worked For Canada Vaccinations Have Worked For Canada Chart I-2CAD/USD An Outperformer This Year An Update On The Canadian Dollar An Update On The Canadian Dollar In our October 20, 2020 report, we suggested the loonie will hit 82 cents, a level around which it peaked this year. Going forward, the key question is whether Canada’s vaccination success will allow the loonie to eventually overtake these highs. The outlook hinges on two critical calls: What happens to natural resource prices, specifically crude oil; and the Bank of Canada’s (BoC) monetary policy stance relative to the Federal Reserve. Our bias is that a cresting in COVID-19 infections should allow the BoC to reintroduce a hawkish bias in upcoming policy meetings, while oil prices should stay well bid over a cyclical horizon. This will allow the loonie to strengthen in a 12-18 month timeframe. This said, we also expect the loonie to underperform other commodity currencies. Improving Domestic Conditions The latest GDP report out of Canada was surprisingly weak, but by most measures, this represents a temporary blip. Canada is adding jobs at the fastest pace in decades, an average of 102 thousand per month this year. This is leading to the quickest recovery in the unemployment rate on record (Chart I-3). A total of 18.9 million Canadians are currently employed, a smidgen away from the February 2020 high of 19.1 million. At the current pace of job additions, employment should overtake pre-pandemic levels during the next couple of job reports. There remains a sizeable deficit of jobs in service-producing industries (Chart I-4). This suggests that as mobility trends improve, job gains should accrue. The majority of job losses since the pandemic have been in the accommodation, food services, wholesale trade, and retail trade sectors. Chart I-3Canadians Are Quickly Getting Back ##br##To Work Canadians Are Quickly Getting Back To Work Canadians Are Quickly Getting Back To Work Chart I-4Pent Up Recovery In Services Jobs Still Ahead of Us An Update On The Canadian Dollar An Update On The Canadian Dollar Strong employment growth has spurred an improvement in consumer demand. Consumer confidence is rebounding in Canada. Retail sales are robust, having handily overtaken pre-pandemic levels. Mortgage credit has also rebounded amidst low interest rates (Chart I-5).   Chart I-5Lower Rates Are Boosting Household Borrowing Lower Rates Are Boosting Household Borrowing Lower Rates Are Boosting Household Borrowing It is therefore no surprise that inflationary pressures have begun to surface in the Canadian economy. In the latest Business Outlook Survey, capacity pressures were at a decade high. Firms reported that shortages in skilled and specialized labor will persist. There are obviously fewer workers with the skills needed in a post-COVID-19 world, but government support schemes have also eaten up labor supply in traditionally fluid labor demand/supply sectors such as hospitality. Meanwhile, supply bottlenecks have also led to production constraints. This is beginning to show up in the key inflation prints to which the BoC pays attention (Chart I-6). Both the trimmed-mean and median CPI are well above the midpoint of the central bank’s 1%-3% target. While the BoC maintains that some upward pressure on inflation is due to temporary factors, the Canadian unemployment rate is declining faster than that in the US, giving scope for the BoC to normalize policy before the Fed, and putting upward pressure on the CAD (Chart I-7). Asset purchases have already been cut in half from C$4 billion to C$2 billion a week. Chart I-6CPI Is Above Midpoint Of The BoC Target Range CPI Is Above Midpoint Of The BoC Target Range CPI Is Above Midpoint Of The BoC Target Range Chart I-7Canada Versus US ##br##Employment Canada Versus US Employment Canada Versus US Employment Meanwhile, house prices are rising quite strongly. The rise in prices has been very broad based, making housing unaffordable for most Canadians (Chart I-8). Residential investment represents almost 9% of Canadian GDP, a significant chunk of aggregate demand (Chart I-9). This suggests that if left unchecked, a housing market bust will deal a severe blow to the Canadian economy. Chart I-8Surging Home Prices A Headache For The BoC Surging Home Prices A Headache For The BoC Surging Home Prices A Headache For The BoC Chart I-9Canadian GDP Is Highly Exposed To Residential Housing Canadian GDP Is Highly Exposed To Residential Housing Canadian GDP Is Highly Exposed To Residential Housing In a nutshell, despite the BoC standing aside this week, the path of least resistance for Canada is towards tighter monetary policy. This dovetails with the recommendation from our Global Fixed Income Strategy colleagues, who recommend an underweight position in Canadian bonds. Elections And Fiscal Policy A snap federal election will be held in Canada on September 20. Prime Minister Justin Trudeau’s bet is that an astute handling of the pandemic, combined with massive fiscal stimulus, gives him a legitimate shot at a majority government. During his Throne Speech last year, he vowed to do “whatever it takes” to support people and businesses throughout the crisis. The rationale is to deliver on this promise going into 2022. The Conservatives have taken a slight lead over the Liberals in the opinion polls, even though a similar state of affairs did not secure them a victory back in the 2019 election (Chart I-10). In general, the Liberals are pushing for more fiscal spending, but are also focused on issues that Canadians care about, such as housing and climate change. The Conservatives, on the other hand, are focused on balancing the budget, which could jeopardize the nascent economic recovery that Canada currently enjoys. Historically, minority governments tend to be positive for the Canadian dollar, while majority governments generally nudge the loonie lower post-election (Chart I-11). In the current context, a Liberal minority will allow fiscal policy to stay easy, giving room for the BoC to curtail accommodative monetary conditions. Tighter monetary policy and easy fiscal policy tend to be positive for a currency in a Mundell-Fleming framework. Meanwhile, a Conservative minority might dial back a little on fiscal stimulus, but not by much due to political gridlock. Chart I-10Polling Ahead Of The ##br##Election An Update On The Canadian Dollar An Update On The Canadian Dollar Chart I-11Historically, The Market Likes A Minority Government Historically, The Market Likes A Minority Government Historically, The Market Likes A Minority Government In a nutshell, a Liberal minority is likely to be positive for the loonie. Should the Trudeau government win a majority, then fiscal policy might become much more profligate, which will boost inflation expectations in Canada and depress real rates. This will be negative for the loonie, unless the BoC aggressively tightens monetary policy. The Canadian Dollar And Crude Oil The above synopsis highlights that a key driver of the Canadian dollar is the BoC’s monetary policy stance, particularly vis-à-vis the Fed. The other critical variable is what happens to natural resource prices, specifically crude oil. The loonie has a strong correlation with the price of oil, chiefly the Western Canadian Select (WCS) blend (Chart I-12). Chart I-12The Loonie Tracks WCS Oil Prices The Loonie Tracks WCS Oil Prices The Loonie Tracks WCS Oil Prices Going forward, the path for oil prices will be highly dependent on the interplay between demand and supply, especially given the various waves of COVID-19. Oil demand tends to follow the ebbs and flows of the business cycle, with over 60% of global petroleum consumed by the transportation sector. A population under lockdown is negative for crude. Nonetheless, our commodity strategists expect oil prices to average $73 per barrel next year, around today’s levels for Brent, as supply dynamics adjust to the current paradigm. With the WCS blend trading at a discount to this price, there is room for upside surprises due to the following reasons: Investment in the Canadian oil sands has dropped tremendously, while the environmental efficiency (emissions per barrel) has been improving (Chart I-13). This has narrowed the spread between WCS and Brent, something that is likely to persist. Canadian producers have gained market share in the heavy crude oil market, on the back of a drop in Venezuelan production. Production cuts in Alberta have also helped mitigate the oversupply of heavy crude. Canadian oil exports remain near record highs, even though the US is rapidly becoming energy independent (Chart I-14). A lot of refining capacity in the US has been fine-tuned to handle the cheaper, heavier blend from Canada. Finally, pipeline capacity remains a major hurdle in Canada but it is slated to ease. The Trans Mountain Expansion project (590K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed by the end of 2022. Both the Liberals and the Conservatives support the project. This could narrow the discount between WCS and WTI crude oil. Chart I-13Will A Cleaner Oil Sector See A Bottom In Investments? An Update On The Canadian Dollar An Update On The Canadian Dollar Chart I-14The Energy Independent US Still Likes Canadian Oil The Energy Independent US Still Likes Canadian Oil The Energy Independent US Still Likes Canadian Oil Netting it all out, we expect crude oil prices to stay firm, in line with our colleagues at the Commodity and Energy Strategy team, and the Canadian discount not to widen by much. This should provide modest upside for the Canadian dollar, which has lagged the improvement in terms of trade (Chart I-15). It is remarkable that long-term portfolio flows into Canadian assets have started picking up, a sign of bargain hunting by international investors (Chart I-16). This should provide a modest tailwind to the Canadian dollar over the next 9-to-12 months. Chart I-15The Loonie Is Undervalued Based On Terms Of Trade The Loonie Is Undervalued Based On Terms Of Trade The Loonie Is Undervalued Based On Terms Of Trade Chart I-16Will The Rising Capital Inflow Provide A Support For The Loonie? Will The Rising Capital Inflow Provide A Support For The Loonie? Will The Rising Capital Inflow Provide A Support For The Loonie? Investment Implications We expect the CAD/USD to break above the recent 82-cent high, towards 85 and eventually 90 cents. The key catalysts are both favorable interest rates versus the US and a gradual recovery in WCS oil prices as global economic activity picks up. According to our fundamental models, the CAD is still very undervalued (Chart I-17). Chart I-17The Loonie Is Undervalued By 19% According To Our Model The Loonie Is Undervalued By 19% According To Our Model The Loonie Is Undervalued By 19% According To Our Model Chart I-18The NOK Will Lead The CAD ##br##For Now The NOK Will Lead The CAD For Now The NOK Will Lead The CAD For Now Relative to other commodity currencies, the CAD should lag the AUD as the green energy revolution exhibits staying power, which will benefit metals more than oil over the longer term. In the shorter term, Canadian crude is likely to remain trapped in the oil sands for now, while North Sea crude will face fewer transportation bottlenecks. This suggests that the path of least resistance for the CAD/NOK is down (Chart I-18). Rising oil prices are a terms-of-trade boost for oil exporters, but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. This suggests that the CAD has upside against the euro, the Indian rupee, and the Turkish lira. But given that the latter currencies are oversold, we will wait for a better buying opportunity.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter NatGas: Winter Is Coming NatGas: Winter Is Coming Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal NatGas: Winter Is Coming NatGas: Winter Is Coming US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong US Natgas Exports Remain Strong US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth NatGas: Winter Is Coming NatGas: Winter Is Coming Chart 6US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer NatGas: Winter Is Coming NatGas: Winter Is Coming Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps NatGas: Winter Is Coming NatGas: Winter Is Coming The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Aluminum Prices Recovering Aluminum Prices Recovering Chart 10 Weaker USD Supports Gold Weaker USD Supports Gold       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades