Mega Themes

Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Chart 1 Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? ​​​​​​ The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... ​​​​​​ Chart 9B... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking.  If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. Chart 10 ​​​​​​ Chart 11 ​​​​​​ In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. Chart 12 What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. Chart 13 China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). Chart 14 American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2     Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3     See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4     "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn.     Section II: Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Major cryptocurrencies have failed to break above important technical levels. Meanwhile, the appeal of fiat money is increasing as many central banks are reining in monetary stimulus. Cryptocurrencies continue to seriously lag fiat as a unit of account. There has been a surge in the development of central bank digital currencies around the world (CBDCs). This will replicate the advantages and success of cryptos. Cryptocurrencies are unlikely to disappear anytime soon. However, conservative investors should stick with gold and silver. Remain long silver relative to gold, along with a petrocurrency basket (RUB, MXN and COP) versus the euro. Feature Chart I-1Cryptos Are At Important Technical Levels Cryptos At Important Technical Levels Cryptos At Important Technical Levels The world of cryptocurrencies continues to generate headlines. The latest hype is the Shiba Inu coin, created by the anonymous Ryoshi. Shiba Inu’s raison d'être is to kill Dogecoin, another cryptocurrency created in part as a joke, and in part to displace Bitcoin. As these two meme coins compete in a race to the moon (both have done phenomenally well this year), the more important price action has been among the dominant players in the space. Bitcoin peaked near US$67,000 this year and has been facing strong upside resistance just as in April. Similarly, Ethereum has failed to break above the $US4,400 level twice this year. Taken together, both assets are exhibiting a classic double-top formation (Chart I-1). Historically, that has been symptomatic of a non-negligible drawdown. The Merit (Or Not) Of Cryptocurrencies Chart I-2 Our first report on cryptocurrencies suggested that they deserved merit.  For one, blockchain technology provides a decentralized, peer-to-peer system, which alleviates the need for an intermediary to validate transactions and arbitrate disputes. This is good news for transaction costs and will likely upend a few business models soon (banking, law, and so forth). This process of creative destruction is exactly what a society needs to become more productive. The fact that the creation, distribution, and use of cryptocurrencies is outside the purview of central banks also enhances the autonomy and anonymity of cryptos, an important feature for many users. Meanwhile, cryptocurrencies have been improving as a medium of exchange. The ability to swap fiat currency into Bitcoins, Ethereum or even Dogecoins and back is fairly easy. In a nutshell, the global turnover of cryptocurrencies has been rising rapidly. On the flip side, little regulation around cryptos has led to a plethora of alternatives. There are currently about 7000 cryptos in circulation, a feat that seriously challenges their value proposition against fiat debasement (Chart I-2). The Shiba Inu coin has a supply of one quadrillion, almost half of which is claimed to have been “burned.” This is occurring within a context where many central banks are sticking to policy orthodoxy, curtailing quantitative easing (and so curbing the growth of the monetary base), and lifting interest rates. The volatility of cryptocurrencies is a serious drawback as both a store of value and unit of account. As highlighted in Chart I-1, both Bitcoin and Ethereum are at critical technical levels. In a broader sense, the drawdown in cryptocurrency prices has been around 80% a year or 40%-50% over three months (Chart I-3). These are much more volatile than currencies such as the Turkish lira, one of the worst-performing currencies this year. Chart I-3Due For Another 40-50% Drawdown? Due For Another 40-50% Drawdown? Due For Another 40-50% Drawdown? The inherent volatility of cryptos also makes them unsuitable as a unit of account. The world is currently experiencing an inflationary boom. In a world dominated by cryptos, should a price correction occur, it would exacerbate this trend. Shiba Inu coins have fallen in value by around 30% from their peak, while inflation in the US is rising by 5.4% per annum. With both Bitcoin and Ethereum off their highs, a similar or even more significant decline cannot be ruled out. The Return Of Fiat Chart I-4The Carry From Fiat Money Is Improving The Carry From Fiat Money Is Improving The Carry From Fiat Money Is Improving In recent months, central bankers have been staple champions in maintaining their currencies’ purchasing power. The Bank of Canada joined a quorum of central banks in ending quantitative easing this week. A few developed and emerging central banks have already raised interest rates to fend off inflationary pressures (Chart I-4). President Richard Nixon ended dollar convertibility into gold in the 1970s because he believed a fiat money regime was a better solution for the US. In the end, he was right as the real effective exchange rate of the dollar has been rather flat since then (Chart I-5). This has led to the dollar maintaining its reserve status over the last several decades, despite a few challenges over time. This puts cryptocurrencies a long way off from the starting line. Chart I-5Despite Rolling Cycles, The Dollar Has Been Flat Over Time Despite Rolling Cycles, The Dollar Has Been Flat Over Time Despite Rolling Cycles, The Dollar Has Been Flat Over Time More importantly, many fiat currencies are likely to do well next year, which will curb the appeal of cryptos. If Bloomberg estimates are right, the world is about to see a big rotation in growth next year from the US towards other countries which have lagged so far (Chart I-6). In this environment, currencies such as the CAD, AUD, and the Scandinavian currencies will do particularly well. This will provide lots of alternatives to cryptocurrencies. Chart I-6AA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US Chart I-6BA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US Taking a step back, the correlation between the dollar and cryptos has not been straight forward. This year, the dollar is rising along with the price of many cryptocurrencies. In previous years, there was a loose but clear inverse correlation (Chart I-7). Therefore, our bias is that this year’s rise is partly due to overexuberance. Chart I-7Bitcoin And The Dollar Bitcoin And The Dollar Bitcoin And The Dollar Central Bank Digital Currencies Chart I- National governments regulate national currencies. This puts a natural limit to how much widespread acceptance cryptos can achieve before policy makers start clamping down on them. So far, the instances of government intervention is heavily stacking up against cryptos. As the turnover in cryptocurrencies overtakes global trading in various domestic currencies, many countries are moving to ban cryptocurrency transactions (Table I-1). China has been a major case in point. Meanwhile, many central banks are also moving to establish their own digital currencies. According to the Atlantic Council, there are almost 70 CDBCs that are either in the research or development phase or in pilot programs (Map I-1). There is an undeniable benefit to adopting blockchain technology. CDBCs will ensure that many of the advantages of using a cryptocurrency are captured without some of the known pitfalls. Chart I- We highlighted at our conference that many governments will be loathe to relinquish control over money supply. For one, the loss in seigniorage revenue will be significant, to the tune of around $100bn for the US. Second, the use of cryptocurrencies continues to encourage the proliferation of illegal activities, a well-known flaw, and something governments will push back against. Once CDBCs become mainstream, the need for alternative cryptocurrencies will not disappear but fall greatly. In a nutshell, a monetary standard which includes both paper currency and CBDCs will provide the flexibility that central bankers need to smooth out economic cycles, along with the security, speed and low cost offered by cryptocurrencies. The Case For Precious Metals When Bitcoin was first introduced, one of the advantages was its limited supply, to the tune of 21 million coins. This resonated particularly well with anti-fiat enthusiasts who have viewed quantitative easing and rising fiscal deficits as a threat to the purchasing power of fiat money. With the number of cryptocurrencies ballooning to fresh new highs every day, this rationale no longer has solid footing. Within this context, precious metals are becoming attractive, especially in a world where inflation is overshooting, and real rates are deeply negative. On this basis, we went long the silver/gold ratio last week, partly as a hedged play on persistently high inflation and partly because we expect both gold and silver to fare well in this environment (Chart I-8). Silver (and platinum) particularly benefit since they remain a much smaller share of the anti-fiat market (Chart I-9). Chart I-8A Hedged Bet On High Inflation A Hedged Bet On High Inflation A Hedged Bet On High Inflation Chart I-9Cryptos Versus Precious Metals Cryptos Versus Precious Metals Cryptos Versus Precious Metals Central banks (the biggest holders of US Treasuries) will be another big force behind precious metals. Central banks tend to have strong hands. This is because they are ideological while private investors can be swayed by momentum. Since the middle of the last decade, there has been a tectonic shift in central bank purchases of gold, especially from developing nations. For example, China and Russia, countries that have a geopolitical imperative to diversify out of dollars, have almost 4% and 25% respectively of their foreign exchange reserves in gold. An asset backed by strong hands is a very attractive conservative play. Investment Conclusions And Housekeeping The chorus from many central banks over the last few weeks has generally been biased towards less stimulus. This is brightening the outlook for many fiat currencies. We particularly like petrocurrencies (which we bought last week), and the Scandinavian currencies which are a cheap play on dollar downside. Oil prices will likely stay elevated in the coming months, especially given that the forward curve remains very backwardated, and could be subject to upward reprising, according to our colleagues in the Commodity & Energy Strategy. As such, a bet on being long oil producers versus consumers will prove profitable. In a nutshell, many petrocurrencies provide an attractive relative carry, and as a lot of oil players see a rebound in their domestic economies, real rates should improve further. Finally, cryptocurrencies are due for a relapse from a technical standpoint. We continue to believe that cryptocurrencies will have intermittent rallies, and as such can be wonderful speculative instruments. However, rising regulation and the proliferation of CBDCs pose a structural threat.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The US economy has been softening of late: The manufacturing PMI fell from 60.7 to 59.2 in October. The Chicago Fed National activity index was also soft, falling from 0.29 to -0.13 in September. House prices in the US continue to inflect higher to the tune of 20% year-on-year. The conference board consumer confidence index was rather upbeat. The present situation rose from 143.4 to 147.4 and the expectations component rose from 86.6 to 91.3. Durable goods orders softened by 0.4% month-on-month in September. The Q3 GDP report was rather weak, rising only 2% quarter-on-quarter (annualized). The US dollar DXY index fell this week. A chorus of central banks have been more proactive curtailing accommodative policy settings, as inflation pressures remain front and center. This is boosting confidence in most procyclical currencies and pressuring the dollar lower.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data also on the softer side this week: The manufacturing PMI was relatively flat, at 58.5 in October. Both consumer and industrial confidence were rather flat in October as well. The ECB kept monetary policy on hold at this week’s meeting. The euro was up 0.3% this week. The markets continue to challenge Governor Christine Lagarde’s dovish stance with both euro area bonds yields and the euro rising amidst a rather dovish communique. This is because in the current environment, global, as well as domestic conditions, are important for the euro area. And the global landscape suggests inflation might be more sticky than central banks expect, warranting a tighter monetary policy stance.  Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been weak: Departmental store sales both in Tokyo and nationwide were rather weak in September. In Tokyo they rose only 0.7% year-on-year. Nationwide, they fell 4.3% year-on-year. Retail sales were weak but beat expectations. The came in -0.6% year-on-year, but with a 2.7% month-on-month increase. The Bank of Japan kept policy on hold, even though it downgraded its forecasts. The yen was flat this week. The yen is in a stalemate as we await the results of the October 31 Japanese elections. Our report next week will be solely focused on this. From a contrarian standpoint, we remain bullish the yen as it is one of the most shorted G10 currencies. Meanwhile, Japanese data could positively surprise to the upside. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent UK data has been rather upbeat: The manufacturing PMI rose from 57.1 to 57.7 in October. The service PMI rose from 55.4 to 58. CBI retailing reported sales rose from 11 to 30 in October. Retail sales were rather weak in September, falling 1.3%. The pound rose by 0.3% this week. We continue to believe the hawkish shift priced in by markets for the BoE is overdone. We remain bullish sterling on a cyclical horizon but are also long EUR/GBP tactically as a play on a policy convergence between the BoE and the ECB. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The inflation data out of Australia was rather strong: Q3 CPI rose 3% year-on-year. The trimmed-mean number was 2.1%, like the trimmed-median print. The import price index surged 5.4% quarter-on-quarter in Q3. The AUD rose 0.9% this week. The RBA has been one of the most dovish central banks in the G10, communicating no interest rate increase until at least 2024. This has put downward pressure on the AUD, setting the stage for a coiled-spring rebound. Meanwhile, the AUD is cheap, especially on a terms of trade basis. At the crosses, we are long AUD/NZD as a play on these trends. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data out of New Zealand this week was on the weaker side: The ANZ consumer confidence index fell from 104.5 to 98 in October. Exports were flattish near NZ$4.40bn in September. The NZD rose by 0.5% this week. Of all the central banks we follow, the RBNZ might be more prone to a policy error should inflation prove to be transitory, and/or a housing slowdown develops, especially if triggered by higher mortgage rates.  At 2.6%, New Zealand currently has the highest G10 10-year rate. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced in. This provides room for disappointment. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The Bank of Canada decision was the main highlight this week: Retail sales remained robust at 2.1% month-on-month in August. The Bloomberg nanos confidence index was flat at 59 for the week of October 22. The Bank of Canada kept rates on hold at its latest policy meeting. The CAD has been flat this week. The BoC delivered a hawkish message, ending QE and signaling that interest rate increases could occur sooner than the market expects. Our thesis this year has always been that on a cyclical basis, the CAD is backed by robust oil prices, and an orthodox central bank that will raise rates to curb high inflation and real estate speculation. As such, our bias is that the path of least resistance for the CAD is up. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Total sight deposits were flat at CHF 715.3bn in the week ended October 22. The Credit Suisse survey expectations fell from 25.7 to 15.6 in October. CHF rose by 0.5% this week. We remain long CHF/NZD on a bet that volatility in currency markets will eventually rise. That said, the SNB will likely be that last central bank to curtail monetary accommodation. This suggests that CHF will lag both the EUR and other European currencies over a cyclical horizon. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: Retail sales rose 0.5% month-on-month in September. The unemployment rate fell from 4.2% to 4.0% in August. The NOK was up 0.3% this week. We continue to believe being long the NOK is the sweet spot in currency markets. The central bank has hiked interest rates, oil prices are robust and the Norwegian economy is on the mend. As such, stay short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Data out of Sweden this week has been rather robust: PPI rose 17.2% year-on-year in September. The trade balance came in at a surplus of SEK 6.3bn in September, a big swing from the August deficit of SEK 10.3bn. Manufacturing confidence rose from 126.6 to 128.5 in October. Q3 GDP came in at 4.7% year-on-year, well above expectations of a 3% quarter-on-quarter rise. Retail sales also rose 4.8% year-on-year in September. The SEK rose by 80 bps this week. We remain short both EUR/SEK and USD/SEK as reflation plays. Incoming data continues to suggest the Swedish economy remains on a mend, even if slowing from stronger growth earlier this year. This could lead to a hawkish surprise from the Riksbank should economic conditions remain robust. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned about the trebling of the crude oil price since March 2020? Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold The Korean Won Is Oversold The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##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 As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 6BSouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 10South Asia Is Young And Will Age Slowly South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater   Chart 11Social Complexities Are High In Afghanistan & Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 18South Asia: The New Epicenter For Nuclear Activity South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater

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

Highlights Taiwan remains the epicenter of global geopolitical risk, as highlighted by the past week’s significant increase in saber-rattling around Taiwan and across East Asia and the Pacific. Tensions may subside in the short run, as the US and China resume high-level negotiations. But then again they may not. And they will most likely escalate over the long run. Investors should judge the Taiwan scenario based on China’s capabilities rather than intentions. China’s intentions may never be known but it is increasingly capable of prevailing in a war over Taiwan. Before then, economic sanctions and cyber attacks are highly likely. The US has a history of defending Taiwan from Chinese military threats. Washington is trying to revive its strategic commitment to Asia Pacific. But US attempts to increase deterrence could provoke conflict. The simplest solution to Taiwan tensions is for a change of party in Taiwan. This would require an upset in the 2022 and especially 2024 elections. China may try to arrange that. Otherwise the risk of conflict will increase. A sharp economic slowdown in China is the biggest risk for investors, as it would not only be negative for the global economy but also would threaten domestic political stability, discredit the gradual and non-military approach to incorporating Taiwan, and boost nationalist and jingoistic pressures directed against Taiwan. Feature Chart 1China's Confluence Of Internal And External Risks China's Confluence Of Internal And External Risks China's Confluence Of Internal And External Risks China faces a historic confluence of internal and external political risks. This was our key view for 2021 and it continues to be priced by financial markets (Chart 1). The latest example of these risks is the major bout of saber-rattling over Taiwan. The US sent two aircraft carriers, and the UK one carrier, to the waters southwest of Okinawa for naval drills with Japan, Canada, the Netherlands, and New Zealand. Related drills are occurring across Southeast Asia, including Vietnam, Singapore, Malaysia, and others. Meanwhile the Chinese air force let loose its largest yet intrusion into Taiwan’s air defense identification zone (Chart 2). The US assured Japan that it would defend the disputed Senkaku islands, while Japan said that it would seek concrete options – beyond diplomacy – for dealing with Chinese pressure. Chart 2China’s Warning To Taiwan Biden, Xi, And Taiwan Biden, Xi, And Taiwan Chart 3Market Response To Saber-Rattling Over Taiwan Strait Market Response To Saber-Rattling Over Taiwan Strait Market Response To Saber-Rattling Over Taiwan Strait Yet, at the same time, a diplomatic opening emerged between the US and China. A virtual summit is expected to be scheduled between Presidents Joe Biden and Xi Jinping. The Biden administration unveiled its review of US trade policy toward China, with mixed results (i.e. imply a defensive rather than offensive trade policy). China offered to join the Trans-Pacific Partnership trade deal (the CPTPP). All sides exchanged prisoners, with Huawei’s Meng Wanzhou back in China. In the short run global investors will cheer attempts by the US and China to stabilize relations. But over the long run tensions over Taiwan suggest the underlying US-China strategic confrontation will persist. We do not doubt that global risk appetite will improve marginally on the news, including toward Chinese and Taiwanese assets (Chart 3). But investors should not mistake summitry for diplomacy, or diplomacy for concrete and material strategic de-escalation. The geopolitical outlook is gloomy for China and Taiwan. Grand Strategies Collide US grand strategy forbids countries from creating regional empires lest they challenge the US for global empire. China has the long-term potential to dominate the eastern hemisphere. The US now quite explicitly seeks to counter China’s growing economic, technological, military, and political influence. China’s grand strategy forbids countries from interfering in its domestic affairs and undermining its economic and political stability. This could include eroding its territorial integrity, jeopardizing its supply security, or denying its maritime access. The US still has considerable capabilities on this front, particularly due to its control of the oceans and special relationship with Taiwan, the democratic island that China claims as a province but that the US supplies with arms. Historically, the Kingdom of Tungning (1661-83) exemplifies that a rival political and naval power rooted in Taiwan can jeopardize the security of southern China and hence all of China (Map 1). Taiwan’s predicament is geopolitically unsustainable and the difference between the past 72 years and today is that Beijing increasingly has the military means of doing something about it. Map 1Why Taiwan’s Status Quo Is Geopolitically Unsustainable Biden, Xi, And Taiwan Biden, Xi, And Taiwan China seeks to establish maritime access, expand its navy, and improve supply security. This process points toward turf battles with the US and its allies and could easily lead to conflict over Taiwan, the East and South China Seas, and other strategic approaches to China. It could also lead to conflict over technological access. The latter is an economic and supply vulnerability that relates directly to Taiwan, which produces the world’s most advanced computer chips. The Chinese strategy since the Great Recession, under two presidents of two different factions, has been to take a more assertive stance on domestic and foreign policy, economic policy, territorial disputes, and supply security. This hawkish turn occurred in response to falling potential GDP growth, which ultimately threatens social stability and the survival of the political regime. Hong Kong was long the symbol that the western liberal democracies could coexist with the Chinese Communist Party. China’s reduction of Hong Kong’s political autonomy over the past decade violated this understanding. Taiwan is now increasingly concerned about its autonomy while the West is looking to deter China from attacking Taiwan. China is willing to wage war if the West attempts to make Taiwan’s autonomous status permanent through increased military support. The US strategy since the Great Recession, under three presidents of two different parties, has been to raise the costs on China for its increasingly assertive policies, particularly in acquiring technology and using economic and military coercion against neighbors. The US is increasing its use of sanctions, secondary sanctions, tariffs, export controls, cyber warfare, and regional strategic deterrence. Hence the policy consensus in both the US and China is more confrontational than cooperative. The Biden administration is largely maintaining President Trump’s punitive measures toward China while trying to build an international coalition to constrain China more effectively. Meanwhile the Xi administration is refusing to hand over power to a successor in 2022, so there will not be a change in Chinese strategy. The US is politically divided, a major factor in Beijing’s favor. China is politically unified, particularly on the question of Taiwan. But one area of national consensus in the US is the need to become “tougher” with respect to China. President Trump’s policies and the COVID-19 pandemic reinforced this consensus. The number of Americans who would support sending US troops to Taiwan if China invaded has risen from 19% in 1982 to 52% today – meaning that the country is divided but fear of China is driving a shift in opinion.1 Chart 4Taiwan Strait Risk Shoots Up To 1950s Levels And Beyond Biden, Xi, And Taiwan Biden, Xi, And Taiwan The China Cross-Strait Academy, a new think tank with pro-mainland sympathies, has produced a Cross Strait Relations Risk Index that goes back to 1950 and utilizes 59 factors ranging from politics and diplomacy to military and economics. It suggests that tensions have reached historically high levels, comparable to the 1950s, when the first and second Taiwan Strait crises occurred (Chart 4). Beware Chinese Economic Crisis – Or Concerted US Action Tensions across the Taiwan Strait began to rise in 2012 when the Communist Party adopted a more hawkish national policy in response to potential threats to its long-term rule arising from the Great Recession. The 2014 “Sunflower Protests” in Taiwan and “Umbrella Protests” in Hong Kong symbolized the rise in tension as Beijing sought to centralize control across Greater China. Support for the political status quo in Taiwan peaked around this time, although most Taiwanese still prefer the status quo to any final decision on the island’s status, which could trigger conflict (Chart 5). China’s militarization of rocks and reefs in the South China Sea throughout the 2010s gave it greater control over the strategic approaches to Taiwan. Since 2016, we have argued that geopolitical risk in the Taiwan Strait would rise on a structural, long-term basis for the following reasons: (1) China’s economic downshift triggered power consolidation and outward nationalism (2) Taiwanese opinion was shifting away from integration with the mainland (3) the US was attempting a strategic shift of focus back to Asia and countering China. Underlying this assessment was the long-running trend of rising support for independence and falling support for unification with China (Chart 6). Chart 5Taiwanese Favor Status Quo Indefinitely Biden, Xi, And Taiwan Biden, Xi, And Taiwan Chart 6Very Few Taiwanese Favor Reunification, Now Or Later Biden, Xi, And Taiwan Biden, Xi, And Taiwan China’s crackdown on Hong Kong from 2016-19 escalated matters further as it removed the “one country, two systems” model for Taiwan (Chart 7). China continues to insist on this solution. In 2013 and again in 2019, Xi Jinping declared that the Taiwan problem cannot be passed down from one generation to another, implying that he intended to resolve the matter during his tenure, which is expected to extend through 2035. Whether Xi has formally altered China’s cross-strait policy is debatable.2 But his use of military intimidation is not. The US policy of “strategic ambiguity” is debatable but the historical record is clear. In the three major crises in the Taiwan Strait (1954-55, 1958, and 1995-96), the US has sent naval forces to the area and clearly signaled that it would defend Taiwan against aggression.3 However, in diplomatic matters, the US has constantly downgraded Taiwan: for instance, transferring its United Nations seat to China in 1971, revoking its mutual defense treaty in 1980, and prioritizing economic cooperation with China in recent decades. The implication is that the US will not stand in the way of unification unless Beijing attempts to achieve it through force of arms. China’s conclusion from US behavior must be that it can definitely overtake Taiwan by means of economic attraction and diplomacy over time. For example, Beijing’s assertion of direct control over Hong Kong took 20 years and ultimately occurred without any resistance from the West. By contrast, a full-scale attack poses major logistical and military risks and potentially devastating costs if the US upholds its historic norm of defending Taiwan. China’s economy and political system could ultimately be destabilized, despite any initial nationalistic euphoria. Taiwan’s wealth (and semiconductor fabs) would be piles of ash. Of course, Taiwan is different from Hong Kong. The Taiwanese people can believe realistically that they have an alternative to direct rule from Beijing. If mainland China’s economic trajectory falters then the option of absorbing Taiwan gradually will fall away. Today about 30%-40% of Taiwanese people believe cross-strait economic exchange should deepen (Chart 8). Only one period of Taiwanese policy since 1949, the eight years under President Ma Ying-jeou (2008-16), focused exclusively on cross-strait economic integration and deemphasized the tendency toward greater autonomy. If China’s economic prospects dim, then Beijing will become more inclined toward the military option, both to distract from domestic instability and to prevent Taiwan from entertaining independence. Chart 7Taiwanese Oppose "One Country, Two Systems" Biden, Xi, And Taiwan Biden, Xi, And Taiwan Chart 8Taiwanese Not Enthusiastic About Cross-Strait Economic Integration Biden, Xi, And Taiwan Biden, Xi, And Taiwan Chart 9Taiwanese Identify Exclusively As Taiwanese, Not Chinese Biden, Xi, And Taiwan Biden, Xi, And Taiwan Most likely China already has the capability to fight and win a war within the “first island chain,” including over Taiwan, especially if US intervention is hesitant or limited. But any doubts will likely be dispelled in the coming years. As long as China’s military advantage continues to grow, Beijing will increasingly view Taiwan as an object that it can take at will, regardless of whether economic gradualism would eventually work. The Taiwanese increasingly view themselves as distinctly Taiwanese – not Chinese or a mix of Taiwanese and Chinese (Chart 9). The implication is that it may be too late for China to win over hearts and minds. However, Beijing will presumably want to see whether Taiwan’s pro-independence Democratic Progressive Party (DPP) can be dislodged from power in the 2024 elections before making a drastic leap to war. Taiwan, like the US and other democracies, is internally divided. President Tsai Ing-wen’s narrative of Taiwan’s democratic triumph over authoritarianism is not only applied to the mainland but also directed against Taiwan’s own Kuomintang (KMT).4 The country is unified on its right to expand economic and diplomatic cooperation with the West but it is starkly divided on whether the US should formally ally with Taiwan, sell it arms, and defend it from invasion (Chart 10A). Kuomintang supporters say they are not willing to fight and die for Taiwan in the face of any invasion (Chart 10B). American policymakers complain that Taiwan’s military structure and policies – long managed by the KMT – are not seriously aimed at preparing for asymmetric warfare against Chinese invasion. Chart 10ATaiwan Divided On Whether US Should Increase Military And Strategic Support Biden, Xi, And Taiwan Biden, Xi, And Taiwan Chart 10BTaiwan Divided On War Sacrifice Biden, Xi, And Taiwan Biden, Xi, And Taiwan The international sphere also matters for Beijing’s calculus. If the US remains divided and distracted – and allies curry favor with China – then China will presumably continue the gradualist approach. But if the US unifies at home and forges closer ties with allies, aiming to curb China’s economy and defend Taiwan’s democracy, then China may be motivated to take military action sooner. If the US and allies want to deter an attack on Taiwan, they need to signal that war will exact profound costs on China, such as crippling economic sanctions, a full economic blockade, or allied military intervention. But the West’s attempts to increase deterrence could spur China to take action before the West is fully prepared. Unlike the US in the Cuban Missile Crisis, China cannot accept a defeat in any showdown over arms sales to Taiwan. Its own political legitimacy is tied up with Taiwan, contrary to that of the US with Cuba. Given the lack of American willingness to fight a nuclear war over a non-treaty ally, the probability of China launching air strikes would be much higher (Diagram 1). Diagram 1Game Theory Of A Fourth Taiwan Strait Crisis Biden, Xi, And Taiwan Biden, Xi, And Taiwan The US is not trying to give Taiwan nuclear arms, or other game-changing offensive systems, although the US has sent marines and special operations forces to help train Taiwanese troops. It is up to Beijing when to make an ultimatum regarding US military support.5 Ultimately the US still controls the seas and China depends on the Persian Gulf for nearly half of its oil imports. This is a good reason for China not to invade Taiwan. But if the US imposes an oil blockade, then the US and China will go to war – this is how the US and Japan came to blows in World War II. The danger is that China assesses that the US will not go that far. Will Biden-Xi Summit Reduce Tensions? Not Over The Long Run True, strategic tensions could be calmed in the short run. The US is restarting talks with China and setting up a bilateral summit between Presidents Biden and Xi. The two sides have exchanged prisoners (e.g. Meng Wanzhou), held climate talks, and Beijing has offered to join the Trans-Pacific Partnership. The US Trade Representative is suggesting it could ease some of President Trump’s tariffs under pressure from corporate lobbyists. The Biden administration is also likely to seek Beijing’s cooperation in other areas, such as North Korea and Iran. Biden has an urgent problem with Iran and may need China’s help constraining Iran’s nuclear program. However, none of the current initiatives change the underlying clash of grand strategies outlined above. A fundamental US-China reengagement is not in the cards. China is adopting nationalism and mercantilism to deal with its slowing potential growth, while China-bashing is one of the few areas of US national consensus. Specifically: Democracy over autocracy: The Biden administration cannot afford to be seen as smoothing the way for Xi Jinping to restore autocracy in the twentieth National Party Congress 12 months from now. China doubles down on manufacturing: China is not making liberal reforms to its economy to lower trade tensions but rather doubling down on state-led manufacturing and technological acquisition, according to the US Trade Representative.6 The US trade deficit is surging due to US fiscal stimulus. Biden will maintain or even expand high-tech export controls. Climate cooperation is limited: The US public does not agree that it should exchange its homegrown fossil fuels for Beijing’s renewable energy equipment, and the US and EU are flirting with “carbon adjustment fees,” which would be tariffs on carbon-intensive goods imports from places like China. Meanwhile China just told its state-owned enterprises to do everything in their power to secure coal for electricity and ordered banks to lend more to coal companies. North Korea is already a nuclear-armed state, which China condoned, despite multiple rounds of negotiations with the West. No agreement on Iran: If China helps force Iran to accept restrictions on its nuclear program, then that could mark a substantial improvement. But China has made long term commitments to Iran recently and probably will not backtrack on them unless the US makes major concessions that would undermine its attempts to counter China. The Taiwan conundrum undermines trust. If China can be brought to help the US with historic deals on North Korea or Iran, it will expect the US to stand back from Taiwan. The US may not see it that way. A failure to do so will appear a betrayal of trust. Consider China’s bid to join the Trans-Pacific Partnership. China’s state-driven economic model is fundamentally at odds with the TPP. It only takes one member to veto China’s membership, and Australia and Japan would defer to the US on this issue. The US is only likely to rejoin the TPP, which requires Republican support in Congress, on the basis that it is a vehicle for countering China. Even if the TPP members could be convinced to accept China, they would also want to accept Taiwan, which Beijing would refuse. Ultimately if China’s membership is vetoed, then it will conclude that the West is not serious about economic integration. China will be excluded and will be more inclined to pursue its own solutions to problems. China possesses or is close to possessing the capability of taking Taiwan by force today. We cannot rule it out. Taiwanese Defense Minister Chiu Kuo-cheng just claimed it could be attempted as early as 2025. Other estimates point to important Chinese calendar dates as deadlines for Taiwan’s absorption: 2027 (centenary of the People’s Liberation Army), 2035 (Xi Jinping’s long-term policy program), and 2049 (centenary of the People’s Republic of China). The truth is that any attack on Taiwan would not be based on symbolic anniversaries but on maximizing the element of surprise, China’s military capabilities, and foreign lack of readiness and coordination. Given that China’s capabilities are in place, or nearly in place, and nobody can predict such things precisely, investors should be prepared for conflict at any time. Investment Takeaways Chart 11Taiwanese Dollar Strengthened Since Trump Taiwanese Dollar Strengthened Since Trump Taiwanese Dollar Strengthened Since Trump The Taiwanese dollar has rallied since the escalation of US-China strategic tensions in 2016. The real effective exchange rate is now in line with its historic average after a long period of weakness (Chart 11). The trade war and COVID-19 have reinforced Taiwan’s advantage as a chokepoint for semiconductors and tech exports. If we thought there was no real risk of a war, we would not stand in the way of this rally. But based on geopolitical assessment above, the rally could be cut short at any time. Taiwanese equities have also rallied sharply for the same reasons – earnings have exploded throughout the pandemic and semiconductor shortage (Chart 12). Equities are not overly expensive on a cyclically adjusted price-to-earnings basis. But they are meeting resistance at a level that is slightly above fair value. Again, the macro and market fundamentals are positive but geopolitics is deeply negative. We remain underweight Taiwan. China’s willingness to try to stabilize relations with the US is an important positive sign that global investors will cheer in the short run. However, with the US economy fired up, and China’s export machine firing on all cylinders, Chinese authorities apparently believe they can maintain relatively tight monetary, fiscal, and regulatory policy, according to our Emerging Markets Strategy and China Investment Strategy. This will lead to negative outcomes in China’s economy and financial markets. The domestic economy is weak and animal spirits in the private sector are depressed. Retail sales, for example, have dropped far beneath their long-term trend (Chart 13). Chart 12Taiwanese Stocks Not Exactly Cheap Taiwanese Stocks Not Exactly Cheap Taiwanese Stocks Not Exactly Cheap Chart 13China: Consumer Sentiment Weak China: Consumer Sentiment Weak China: Consumer Sentiment Weak The regulatory crackdown on the property sector could trigger an economic and financial crisis (Chart 14). Chinese onshore equity markets were ultimately not able to sustain the collapse in sentiment this year that hit offshore equities even harder. China’s technology sector will continue to struggle under the burden of hawkish regulation, while Chinese stocks ex-tech have long underperformed the broad market (Chart 15). Chart 14China's Huge Property Sector Looking Wobbly China's Huge Property Sector Looking Wobbly China's Huge Property Sector Looking Wobbly Chart 15Beware Financial Turmoil In Mainland China Beware Financial Turmoil In Mainland China Beware Financial Turmoil In Mainland China We maintain the view that Chinese authorities will ease policy when necessary to try to prevent deleveraging in the property sector from triggering a crisis ahead of the twentieth national party congress. A look at past five-year political rotations suggests that bank loans will be flat-to-up over the coming 12 months and that fixed asset investment will tick up (Chart 16). But as long as policymakers are reluctant, risks lie to the downside for Chinese assets and related plays. Chart 16National Party Congress 2022 Requires Overall Stability National Party Congress 2022 Requires Overall Stability National Party Congress 2022 Requires Overall Stability Chart 17GeoRisk Indicators Flash Warnings GeoRisk Indicators Flash Warnings GeoRisk Indicators Flash Warnings China’s shift from “consensus rule” to “personal rule,” i.e. reversion to strongman rule or autocracy, permanently increases the risk of policy mistakes. This could apply to fiscal and regulatory policy as much as to cross-strait policy or foreign policy. It is appropriate that our geopolitical risk indicators for China and Taiwan are rising, signaling that equities are not yet out of the woods (Chart 17). Over the long run China is capable of staging a surprise attack and defeating Taiwan. We have argued that the odds are small this year but that some crisis is imminent – and that the risk of war will rise in the coming years. This is especially true if China cannot engineer a recession to get the Kuomintang back into power in 2024. However, from a fundamentally geopolitical point of view, any attack is bound to be a surprise and hence investors should be prepared. The three main conditions for a conflict over Taiwan are: (1) Chinese domestic instability (2) an American transfer of game-changing offensive weapon systems to Taiwan (3) a formal Taiwanese movement toward independence. The likeliest of these, by far, is Chinese instability.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Dina Smeltz and Craig Kafura, "For First Time, Half Of Americans Favor Defending Taiwan If China Invades," Chicago Council on Global Affairs, August 26, 2021, thechicagocouncil.org. 2 See Lu Hui, "Xi says ‘China must be, will be reunified’ as key anniversary marked," Xinhua, January 2, 2019, Xinhuanet.com. For a less alarmist reading of Xi’s recent speeches, see David Sacks, "What Xi Jinping’s Major Speech Means For Taiwan," Council on Foreign Relations, July 6, 2021, cfr.org. 3 See Ian Easton, "Will America Defend Taiwan? Here’s What History Says," Strategika, Hoover Institution, June 30, 2021, hoover.org. 4 See Tsai Ing-wen, "Taiwan and the Fight for Democracy," Foreign Affairs, November/December 2021, foreignaffairs.com. 5 See Gordon Lubold, "U.S. Troops Have Been Deployed In Taiwan For At Least A Year," Wall Street Journal, October 7, 2021, wsj.com. 6 Office of the US Trade Representative, "Fact Sheet: The Biden-Harris Administration’s New Approach To The U.S.-China Trade Relationship," October 4, 2021, ustr.gov.

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

Highlights The fourth quarter will be volatile as China still poses a risk of overtightening policy and undermining the global recovery. US political risks are also elevated. A debt default is likely to be averted in the end. Fiscal stimulus could be excessive. There is a 65% chance that taxes will rise in the New Year. A crisis over Iran’s nuclear program is imminent. Oil supply disruptions are likely. A return to diplomacy is still possible but red lines need to be underscored. European political risks are comparatively low, although they cannot go much lower, Russia still poses threats to its neighbors, and China’s economic wobbles will weigh on European assets. Our views still support Mexican equities and EU industrials over the long run but we are booking some gains in the face of higher volatility. Feature Our annual theme for 2021 was “No Return To Normalcy” and events have borne this out. The pandemic has continued to disrupt life while geopolitics has not reverted to pre-Trump norms. Going forward, the pandemic may subside but the geopolitical backdrop will be disruptive. This is primarily due to Chinese policy, unfinished business with Iran, and the struggle among various nations to remain stable in the aftermath of the pandemic. Chart 1Delta Recedes With Vaccinations Delta Recedes With Vaccinations Delta Recedes With Vaccinations Chart 2Global Recovery Marches On Global Recovery Marches On Global Recovery Marches On Chart 3Global Labor Markets On The Mend Global Labor Markets On The Mend Global Labor Markets On The Mend The underlying driver of markets in the fourth quarter will be the fact that the COVID-19 pandemic is waning as vaccination campaigns make progress (Chart 1). New cases of the Delta variant have rolled over in numerous countries and in US states that are skeptical toward vaccines. Global growth will still face crosswinds. US growth rates are unlikely to be downgraded further while Europe’s growth has been upgraded. However, forecasters are likely to downgrade Chinese growth expectations in the face of the government’s regulatory onslaught against various sectors and property sector instability (Chart 2). Barring a Chinese policy mistake, the global composite PMI is likely to stabilize. Labor markets will continue healing (Chart 3). The tug of war between unemployment and inflation will continue to give way in favor of inflation, given that wage pressures will emerge, stimulus-fueled household demand will be strong, and supply shortages will persist. Central banks will try to normalize policy but will not move aggressively in the face of any new setbacks to the recovery. Will China Spoil The Recovery? Maybe. Chinese policy and structural imbalances pose the greatest threat to the global economic recovery both in the short and the long run. The immediate risk to the recovery is clear from our market-based Chinese growth indicator, which has not yet bottomed (Chart 4). The historic confluence of domestic political and geopolitical risks in China is our key view for the year. China is attempting to make the economic transition that other East Asian states have made – away from the “miracle” manufacturing phase of growth toward something more sustainable. But there are two important differences: China is making its political and economic system less open and free (the opposite of Taiwan and South Korea) and it is confronting rather than befriending the United States. The Xi administration is focused on consolidating power ahead of the twentieth national party congress in fall 2022. Xi is attempting to stay in power beyond the ten-year limit that was in place when he took office. On one hand he is presenting a slate of socioeconomic reforms – dubbed “common prosperity” – to curry popular favor. This agenda represents a tilt from capitalism toward socialism within the context of the Communist Party’s overarching idea of socialism with Chinese characteristics. On the other hand, Xi is cracking down on the private sector – Big Tech, property developers – which theoretically provides the base of power for any political opposition. The crackdowns have caused Chinese equities to collapse relative to global and have reaffirmed the long trend of underperformance of cyclical sectors relative to defensives within Chinese investable shares (Chart 5, top panel). Chart 4China Threatens To Spoil The Party China Threatens To Spoil The Party China Threatens To Spoil The Party In terms of financial distress, so far only high-yield corporate bonds have seen spreads explode, not investment grade. But current policies force property developers to liquidate their holdings, pay off debts, and raise cash while forcing banks to cut bank on loans to property developers and homebuyers. (Not to mention curbs on carbon emissions and other policies squeezing industrial and other sectors.) Chart 5Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot If these policies are not relaxed then property developers will continue to struggle, property prices will fall, credit tightening will intensify, and local governments will be starved of revenue and forced to cut back on their own spending. Yet the government’s signals of policy easing are so far gradual and behind the curve. If policy is not relaxed, then onshore equities will sell off (as well as offshore) and credit spreads will widen more generally (Chart 5, bottom panel). Broad financial turmoil cannot be ruled out in the fourth quarter. Ultimately, however, China will be forced to do whatever it takes to try to secure the post-pandemic recovery. Otherwise it will instigate a socioeconomic crisis ahead of the all-important political reshuffle in fall 2022. That would be the opposite of what Xi Jinping needs as he tries to consolidate power. Chinese households have stored their wealth, built up over decades of economic success, in the housing sector (Chart 6). Economic instability could translate to political instability. Chart 6Beijing Will Provide Bailouts And Stimulus … Or Face Political Instability Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Investors often ask how the government can ease policy if doing so will further inflate housing prices, which hurts the middle class and is the opposite of the common prosperity agenda. High housing prices are the biggest of the three “mountains” that are said to be crushing the common folks and weighing on Chinese birthrates and fertility (the other two are high education and medical costs). The answer is that while policymakers want to cap housing prices and encourage fertility, they must prevent a general collapse in prices and economic and financial crisis. There is no evidence that suppressing housing prices will increase fertility or birthrates – if anything, falling fertility is hard to reverse and goes hand in hand with falling prices. Rather, evidence from the US, Japan, South Korea, Thailand, and other countries shows that a bursting property bubble certainly does not increase fertility or birthrates (Charts 7A and 7B). Chart 7AEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Chart 7BEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Bringing it all together, investors should not play down negative news and financial instability emerging from China. There are no checks and balances on autocrats. Our China Investment Strategy has a high conviction view that policy stimulus is not forthcoming and regulatory curbs will not be eased. The implication is that China’s government could make major policy mistakes and trigger financial instability in the near term before changing its mind to try to preserve overall stability. At that point it could be too late. Will Countries Add More Stimulus? Yes. Chart 8Global Monetary Policy Challenges Global Monetary Policy Challenges Global Monetary Policy Challenges With China’s stability in question, investors face a range of crosswinds. Central banks are struggling with a surge in inflation driven by stimulus-fueled demand and supply bottlenecks. The global output gap is still large but rapid economic normalization will push inflation up further if kinks are not removed (Chart 8). A moderating factor in this regard is that budget deficits are contracting in 2022 and coming years – fiscal policy will shift from thrust to drag (Chart 9). However, the fiscal drag is probably overstated as governments are also likely to increase deficit spending on the margin. The US is certainly likely to do so. But before considering US fiscal policy we must address the immediate question: whether the US will default on national debt. Treasury Secretary Janet Yellen has designated October 18 as the “X-date” at which the Treasury will run out of extraordinary measures to make debt payments if Congress does not raise the statutory debt ceiling. There is presumably a few weeks of leeway after this date but markets will grow very jittery and credit rating agencies will start to downgrade the United States, as Standard & Poor’s did in 2011. Chart 9Global Fiscal Drag Rears Its Head Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Democrats have full control of Congress and can therefore suspend the debt ceiling through a party-line vote. They can do this through regular legislation, if Republicans avoid raising a filibuster, though that requires Democrats to make concessions in a back-room deal with Republicans. Or they can compromise the filibuster, though that requires convincing moderate Democrats who support the filibuster that they need to make an exception to preserve the faith and credit of the US. Or they can raise the debt ceiling via budget reconciliation, though this would run up against the time limit and so far Senate Leader Chuck Schumer claims to refuse this option. While the odds of a debt default are not zero, the Democrats have the power to avoid it and will also suffer the most in public opinion if it occurs. Therefore the debt limit will likely be suspended at the last minute in late October or early November. Investors should expect volatility but should view it as short-term noise and buy on dips – i.e. the opposite of any volatility that stems from Chinese financial turmoil. Congress is likely to pass Biden’s $550 billion bipartisan infrastructure bill (80% subjective odds). It is also likely to pass a partisan social welfare reconciliation bill over the coming months (65% subjective odds). The full impact on the deficit of both bills should range from $1.1-$1.6 trillion over ten years. This will not be enough to prevent the fiscal drag in 2022 but it will provide for a gradually expanding budget deficit over the course of the decade (Chart 10). Chart 10New Fiscal Stimulus Will Reduce Fiscal Drag On Margin Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! The reconciliation package will be watered down and late in coming. Investors will likely buy the rumor and sell the news. If reconciliation fails, markets may cheer, as it will also include tax hikes and pose the risk of pushing up inflation and hastening Fed rate hikes. Elsewhere governments are also providing “soft budgets.” The German election results confirmed our forecast that the government will change to left-wing leadership that will be able to boost domestic investment but not raise taxes. This is due to the inclusion of at least one right-leaning party, most likely the Free Democrats. Fiscal deficits will go up. Germany has a national policy consensus on most matters of importance and thus can pass some legislation. But the new coalition will be ideologically split and barely have a majority in the Bundestag, so controversial or sweeping legislation will be unlikely. This outcome is positive for German markets and the euro. Looking at popular opinion toward western leaders and their ruling coalitions since the outbreak of COVID-19, the takeaway is that the Europeans have the strongest political capital (Chart 11). Governments are either supported by leadership changes (Italy, Germany) or likely to be supported in upcoming elections (France). The UK does not face an election until 2024, unless an early election is called. This seems doubtful to us given the government’s strong majority. Chart 11DM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Chart 12EM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! After all, Canada called an early election and it became a much riskier affair than the government intended and did not increase the prime minister’s political capital. Spain is far more likely to see tumult and an early election. Japan’s election in November will not bring any surprises: as we have written, Kishidanomics will be Abenomics by a different name. The implication is that after November, most developed markets will be politically recapitalized and fiscal policy will continue to be accommodative across the board. In emerging markets, popular opinion has been much more damning for leaders, calling attention to our expectation that the aftershocks of the global pandemic will come in the form of social and political instability (Chart 12). Russia has a record of pursuing more aggressive foreign policy to distract from its domestic ills. The next conflict could already be emerging, with allegations that it is deliberately pushing up natural gas prices in Europe to try to force the new German government to certify and operate the NordStream II pipeline. The Americans are already brandishing new sanctions. Chart 13Stary Neutral Dollar For Now Stary Neutral Dollar For Now Stary Neutral Dollar For Now Brazil and Turkey both face extreme social instability in the lead-up to elections in 2022 and 2023. India has been the chief beneficiary of today’s climate but it also faces an increase in political and geopolitical risk due to looming state elections and its increasing alliance with the West against China. Putting it all together, the US is likely to stimulate further and pump up inflation expectations. Europe is politically stable but Russia disrupt it. Other emerging markets, including China, will struggle with economic, political, and social instability. This is an environment in which the US dollar will remain relatively firm and the renminbi will depreciate – with negative effects on EM currencies more broadly (Chart 13). Annual Views On Track Our three key views for 2021 are so far on track but face major tests in the fourth quarter: 1. China’s internal and external headwinds: If China overtightens policy and short-circuits the global economic recovery, then its domestic political risks will have exceeded even our own pessimistic expectations. We expect China to ease fiscal policy and do at least the minimum to secure the recovery. Investors should be neutral on risky assets until China provides clearer signals that it will not overtighten policy (Chart 14). 2. Iran is the crux of the US pivot to Asia: A crisis over Iran is imminent since Biden did not restore the 2015 nuclear deal promptly upon taking office. Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Brent crude oil prices will see upside risks relative both to BCA forecasts and the forward curve (Chart 15). Chart 14Wait For China To Relax Policy Wait For China To Relax Policy Wait For China To Relax Policy Chart 15Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran The reason is that Iran is expected to reach nuclear “breakout” capability by November or December (i.e. obtain enough highly enriched uranium to make a nuclear device). The Biden administration is focused on diplomacy and so far hesitant to impose a credible threat of war to halt Iranian advances. Israel’s new government has belatedly admitted that it would be a good thing for the US and Iran to rejoin the 2015 nuclear deal – if not, it supports a global coalition to impose sanctions, and finally a military option as a last resort. Biden will struggle to put together a global coalition as effective as Obama did, given worse relations with China and Russia. The US and Israel are highly likely to continue using sabotage and cyberattacks to slow Iran’s nuclear and missile progress. Chart 16Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Chart 17Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Thus the Iranians are likely to reach breakout capability at which point a crisis could erupt. The market is not priced for the next Middle East crisis (Chart 16). Incidentally, any additional foreign policy humiliation on top of Afghanistan could undermine the Biden administration more broadly, in both domestic and foreign policy. 3. Europe benefits most from a post-pandemic, post-Trump world: Europe is a cyclical economy and is also relatively politically stable in a world of structurally rising policy uncertainty and geopolitical risk. We thought it stood to benefit most from the global recovery and the passing of the Trump administration. However, China’s policy tightening has undermined European assets and will continue to do so. Therefore this view is largely contingent on the first view (Chart 17). Investment Takeaways Strategically we maintain a diversified portfolio of trades based on critical geopolitical themes: long gold, short China/Taiwan, long developed markets, long aerospace/defense, long rare earths, and long value over growth stocks. Taiwanese equities have continued to outperform despite bubbling geopolitical tensions. We maintain our view that Taiwan is overpriced and vulnerable to long-term semiconductor diversification as well as US-China conflict. Our rare earths basket, which focuses on miners outside China, has been volatile and stands to suffer if China’s growth decelerates. But global industrial, energy, and defense policy will continue to support rare earths and metals prices. Russian tensions with the West have been manageable over the course of the year and emerging European stocks have outperformed developed European peers, contrary to our recommendation. However, fundamental conflicts remain unresolved and the dispute over the recently completed Nord Stream II pipeline to Germany could still deal negative surprises. We will reassess this recommendation in a future report. We are booking gains on the following trades: long Mexico (8%), long aerospace and defense in absolute terms (4%), long EU industrials relative to global (4%), and long Italian BTPs relative to bunds (0.2%).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Appendix: Geopolitical Calendar

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