Productivity

The stratospheric valuation of this year’s AI mania is likely to deflate, just as it did after the Web 1.0 mania of the late 90s. We go through some long-term and short-term investment implications.

The conventional economic thinking about the likely impact of AI is misguided because it extrapolates linearly from what AI can do today to what it can do tomorrow. Just as the investment community and the broader public were blindsided by the exponential rise in Covid cases during the early days of the pandemic, they will be blindsided by how quickly AI transforms society and the economy.

Innovative Tech will face macroeconomic headwinds in a new “higher for longer” interest regime. Yet, the long-term opportunity of the cohort is tremendous. Investors need to be judicious with the timing of adding new capital to these themes to bolster long-term returns.

China’s labor market is polarized between high unemployment among university graduates and an acute shortage of blue-collar labor. The high jobless rate among young workers is structural and will not decline a lot even during an economic recovery. Given the structural scarcities of blue-collar workers, the authorities will be less inclined to resort to their old playbook of stimulating infrastructure, construction, and manufacturing.

This week’s Special Report goes over the structural problems facing the UK economy and our outlook for UK gilts and the sterling following turbulent moves in 2022.

Heading into a black hole, you pass a point of no return known as the ‘event horizon’ after which your impending oblivion is sealed. US recessions also have an event horizon, which we are fast approaching. We reveal a leading indicator of this event horizon, and what it means for investment strategy.

Web 3.0 plays will boom in the coming decade. Play this through a diversified exposure to today’s main blockchain tokens. But the Web 2.0 oligopolies, like Amazon and Meta, are in big trouble.

Executive Summary Robotization Is Gaining Pace The Robot Revolution The Robot Revolution ​​​​In today’s publication, we will zero in on one of the most exciting areas of technological innovation that also presents substantial long-term investment potential – robotics. The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of favorable long-term trends such as deteriorating global demographics, and a shift of manufacturing toward onshoring and customization. Thanks to technological breakthroughs in the areas of AI, machine learning, lidars, and machine vision, robots are becoming more intelligent and dexterous, thus suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Increased connectivity and broad-based automation and robotization, are ushering in Industrial Revolution 4.0, improving productivity manyfold. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. Bottom Line: Robotics is an exciting story of technological innovation, which also presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, the recent correction in robotics stocks presents an attractive entry point for patient investors with longer investment horizons.     Chart 1US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging Last month we published a report: “Industrials: A Trifecta Of Positives” in which we noted that the US is entering a period of industrial boom prompted by favorable government policy and generous spending, and strong new trends in onshoring and automation (Chart 1). This trifecta of positives helps the sector defy the gravity of the slowing economy.   In this week’s publication, we will zero in on automation and robotization. This is one of the most exciting areas of technological innovation, which presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, robotics ETFs such as BOTZ, ROBO, IRBO, and ROBT are off some 40%-50% from their recent post-pandemic peaks (Table 1) and present an attractive entry point for patient investors with longer investment horizons. Table 1An Attractive Entry Point for Long-term Investors The Robot Revolution The Robot Revolution What Is A Robot? Recent breakthroughs in AI and robotics technology are awe-inspiring and unsettling. The "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity, and the microchip. GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time The most basic definition is "a device that automatically performs complicated and often repetitive tasks". Interestingly, according to the definition of the International Standards Organization (ISO), software (bots, AI, process automation), remotely controlled drones, voice assistants, autonomous cars, ATMs, smart washing machines, etc. are not robots. Broadly speaking, there are three types of robots: Industrial, service, and collaborative (cobots). Industrial robots work on assembly lines in manufacturing, service robots perform necessary as well as potentially harmful tasks for humans, while collaborative robots (or “cobots”) work next to human workers. We will discuss different types of robots in more depth in later sections. Robotics Industry Is Growing Steadily Global Adoption Chart 2Robotization Is Gaining Pace The Robot Revolution The Robot Revolution According to the International Federation of Robotics, as of 2020, industrial robot stock has constituted 3 million units and between 2015 and 2020 has been growing at 13% per year. A total of 383,000 units of industrial robots were installed in 2020. Industrial robots reported record preliminary sales in 2021, with 486,800 units shipped globally, a 27% increase from 2020. The pace of installations is forecasted to stay robust well into 2024 (Chart 2). Service robot adoption has also clearly been crossing the chasm: In 2020, nearly 132,000 service robots were installed, a 41% increase over 2019, and 19 million consumer service robots were installed, a 6% increase over 2019. Together, the service robot turnover was approximately $12 billion in 2020. The US Is Lagging But The Pace Is Accelerating Chart 3Industrial Robots Across The Globe The Robot Revolution The Robot Revolution The US has been lagging other developed countries in terms of automation and robotization (Chart 3). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3), the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots in Q1, a 28% increase over Q1-2021. Multiple Tailwinds Promote Ubiquitous Robotization The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of forces, such as deteriorating global demographics, manufacturing shifts toward onshoring and customization, and technological breakthroughs that make robots more capable and affordable.  Aging Population Leads To Labor Shortages Populations in both developed and emerging markets is aging: More people both in high and upper-middle-income countries will retire in the next decade than will enter the workforce, making labor shortages inevitable. In the US, the problem is particularly acute. Since 2020, labor force participation has declined from 63.4% to 62.4%, most likely due to early retirements, while the unemployment rate stands at a historically low 3.7%. There are two job openings per job seeker, and many businesses report difficulty finding qualified staff. As companies are struggling to fill existing openings, they are increasingly turning towards robots: Replacing labor with automation/robots allows them to produce more and avoid a profit margin squeeze. IFR reports that an increasing number of small- and medium-sized businesses are deploying robots.  Related Report  US Equity StrategyIndustrials: A Trifecta Of Positives Onshoring And Reshoring As we pointed out in the recent report on Industrials, the onset of the pandemic and geopolitical tensions have accelerated the pace of reshoring. Supply chain disruptions have highlighted corporate vulnerabilities and made companies realize that “just-in-case” trumps “just-in-time.” However, companies that bring their businesses back home do realize that finding workers is a challenge, while labor costs are many times higher. Hence, one of the solutions they pursue is automation and robotization.   Mass Customization The “new normal” in many industries is mass customization, i.e., variations for a growing number of products, dubbed a “batch of one.” The shift towards high mix, low volume production raises the importance of manufacturing flexibility and agility – and that is when the industrial robot, capable of working in high to low-volume productions on simple to complex processes, comes to the rescue. The Lower Total Cost Of Ownership Technological advances have made robots both more sophisticated and more affordable. In addition, to a growing supply of low-cost robots, there are also novel pricing models, such as “Robots-as-a-Service” and pay-as-you-use, which support the ubiquitous adoption of robots even by smaller enterprises. Technological Breakthroughs Recent advances in artificial intelligence (AI), computer vision, radars, and networks have expanded the range of tasks that robots can do. Effectively, new technology gives the robot the ability to see, hear, and pick up objects, acting differently according to the data the robot receives, offering it a certain level of autonomous decision-making. Now that robots can “see” and “hear,”, they are being taught how to “feel,” and some of the recent technological advances are truly mind-boggling. Glasgow University researchers have developed ultra-sensitive electronic skin that learns from sensations it experiences. A robotic hand covered with the new e-skin recoiled from what it recognized as “painful” stimuli. This new technology will allow robots to interact with the world in a whole new way, an invention that can be leveraged in a wide range of applications, from prosthetic limbs to the “internet-of-things”.1 And this is just one of many recent inventions. Virtuous Cycle Of Innovation The Robotics industry is going through a perpetual and ever-accelerating cycle of innovation (Chart 4). Improvements to one domain of robotic applications can be transferred to others, benefitting from “adjacent” technologies. In other words, innovations in vacuum cleaners or transport trucks can be easily applied to other areas of robotics, as despite differences in prices and value-add, all the robotic applications are trying to solve the same problems. Advances in different fields in robotics create opportunities for ever more applications, creating a virtuous cycle. Chart 4Robotics Will Enter Into A Virtuous Cycle The Robot Revolution The Robot Revolution Furthermore, robotics is a poster child for Moore’s Law, which refers to the phenomenon whereby transistors on a microchip double every two years, eventually leading to exponential improvements in computing power. Automation and robotics take advantage of these improvements as they are challenged with more complex tasks. We predict the virtuous cycle for robots will span several decades. As the cost of automation drops, better solutions will be developed, resulting in the ‘early retirement’ of dated but otherwise fully functional robotic systems. The following is a brief synopsis of advances in technology and their applications to robotics. Technologies That Help Robots Act Like Humans AI And Machine Learning (ML) AI and ML not only teach robots to perform certain tasks but also makes machines more intelligent by training them to act in different scenarios. To do this, vast amounts of data are consumed. For example, to “teach” a robot to recognize an object and act accordingly, a massive number of images are used to train the computer vision model. Dexterity And Deep Imitation Learning One of the major challenges of roboticists is improving the dexterity of robots and empowering them to manipulate objects gripped by the hand, akin to humans. Some researchers are using machine learning to empower robots to independently identify and work out how to grab objects. Deep Imitation Learning, neural-network-based algorithms, allow the robot to “learn” from humans. For example, in a robotics study led by researchers from the University of Tokyo, the machine learning embedded in the robot practiced a method observed by a human demonstrator. After watching one of the researchers peel a banana periodically for thirteen hours, a robot successfully learned how to peel a banana without crushing the fruit.2 There are also major improvements in hardware, with grippers ranging from pincer-like appendages to human-like hands. Lidar Lidar (Light Detection and Ranging) technology uses sophisticated laser radars that allow robots to navigate their surroundings through object perception, identification, and collision avoidance. Lidar sensors provide information in real-time about the robot’s surroundings such as walls, doors, people, and various objects. While originally expensive, Lidar costs are starting to fall thanks to a more effective chip design and more economical mechanical implementation. Lidars are crucial for advances in industrial automation and warehouse robots. Machine Vision Deep Learning has brought about a groundbreaking advancement in machine vision. One of the early hurdles in machine vision may be described with a simple question: “Am I looking at a large object that’s far away or a tiny object that’s up close?”  The modern approach to answering this question is to use both 3-D cameras and the context. 3-D is simulated by using two or more overlapping cameras, correlating the information on camera movements with changing images from the cameras. Deep Learning algorithms help formulate the context of these changing images.3 Machine vision provides higher quality mapping at a more affordable cost than Lidar, especially when it comes to indoor robotics and automation. Industrial Internet Of Things In Robotics The implementation of the “Industrial Internet of Things” (IIoT) is vital for manufacturing automation and robotics. Its main goal is to create a constant tracking of inputs and outputs, enabling communication along the entire supply chain, passing data between enterprise level and plant floor systems, and improving productivity through the use of big data.  Robots working at different stages of the manufacturing process are interconnected, ensuring flawless production. IIoT technology aims to improve productivity by reducing human-to-human and human-to-computer interactions, reducing costs, and minimizing the probability of mistakes. Similar to smart homes, IIoT factories are smart factories.4 Industrial Revolution 4.0 Early industrial robots performed very specific operations under carefully controlled conditions – an assembly robot that encountered a misaligned component would simply install it that way, resulting in a defective product. However, thanks to improvements in vision systems, computing, AI, and mechanics, the ability of robots to perform increasingly complex tasks that involve some limited decision-making has improved. Increased connectivity, brought about by IIoT, and ubiquitous automation and robotization, are ushering in a new Industrial Revolution, dubbed 4.0. As in previous industrial revolutions, innovation improves productivity manifold. Chart 5Robots Are Proficient In Many Tasks The Robot Revolution The Robot Revolution Industrial robots are deployed to carry out a wide variety of tasks (Chart 5). Arc welding, spot welding, assembly, palletizing, material removal, inspection, material handling, and packaging are some of the most popular applications for robots, but the list does not stop with just those. Industrial robots limit the need for human interaction while being able to complete tasks accurately with a high level of repeatability. Proficiency with these many tasks allows robots to add value to a multitude of industries, such as automotive, electronics, aerospace, food, and medical. While in the past the automotive sector was the key end-demand market for global robotics sales, non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in terms of the purchase of robots (Charts 6 & 7). Chart 6Robots Are Gaining Traction In Multiple Industries The Robot Revolution The Robot Revolution Chart 7In The US, Robotization Is Broad-Based The Robot Revolution The Robot Revolution We expect the rising digitalization of the manufacturing sector to lead to a new wave of automation investment in developed countries. Key Players In Industrial Robots Space The global industrial robotics market is largely dominated by established Japanese and European companies: ABB, Yaskawa, KUKA, and Fanuc. However, the sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the established players, as many industrial companies, such as Rockwell Automation, Eaton, and Caterpillar, are becoming leaders in this new space. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous spring for high-value crops. These companies will benefit from strong demand for their products and should exhibit strong sales and profit growth. Service Robots Are Here To Help Service robots can significantly benefit humans in a variety of fields, including healthcare, automation, construction, household, and entertainment. These robots are managed by internal control systems, with the option of modifying the operation manually. These service robots remove the possibility of human error, manage time, and increase production by lowering the workload of staff and labor. Chart 8Service Robots Across Industries The Robot Revolution The Robot Revolution Service robots are quickly becoming an essential part of business for service-focused companies in healthcare, logistics, and retail (Chart 8). Developments in edge artificial intelligence processors and the arrival of 5G telecom services are likely to propel the market for service robots to new heights. The usage of service robots is extremely broad and range from cleaning to preparing meals to delivering goods. The following are some of the key areas that benefit from service robots. Healthcare Common duties assigned to service robots include setting up patient rooms, tracking inventory and placing orders, and transporting supplies, medication, and linens. Cleaning and disinfection robots can also help create a safe and sanitized facility for everyone. Further, robots assist in performing difficult surgeries and medical procedures.  Robots also help the elderly and disabled. For example, ReWalk has developed a wearable robotic exoskeleton that provides powered hip and knee motion to enable individuals with spinal cord injury (SCI) to stand upright, walk, turn, and climb and descend stairs. The system allows independent, controlled walking while mimicking the natural gait pattern of the legs. Military Defense Autonomous Mobile Robots (AMR) are helpful for combating fires, disarming bombs, and traversing through dangerous areas. Fully automated drone robots are indispensable for military intelligence and combat operations. Logistics As e-commerce sales continue to surge, logistics businesses are using service robots to help overcome current labor shortages, assist current workers to avoid workforce burnout, and enable warehouse automation. Robotic arms are often assigned tasks like picking, placing, and sorting objects, and because these cobots can navigate warehouses independently, they are used to deliver materials to human workers for accurate and efficient order fulfillment. Some logistics companies, such as FedEx, are experimenting with using AMR for last-mile delivery of goods, which is often the most expensive and least productive part of the entire delivery chain. AMR can navigate sidewalks, unpaved surfaces, and steps while carrying cargo. Key Players In Service Robots Space Many US companies are active in this space. Amazon (AMZN) developed robots to support its fulfillment center operation: Robots help automate storage and retrieval mechanisms throughout vast warehouses. IRobot (IRBT) has developed a series of AI-enabled robot vacuums, mops, and pool cleaners – friendly pet-like bots you may see in many American homes. There are also highly sophisticated surgical robots, developed by Stryker (SYK) and Intelligent Surgical (ISRG).  Collaboration Between Humans And Robots Collaboration between humans and robots is still in its infancy but it is one of the fastest-growing fields within robotics. Cobots work alongside humans, allowing humans to be more productive and avoid tedious or strenuous tasks. Cobots can be installed directly in the current production system, with less space than conventional robots. Equipped with intelligent features such as vision and force sensors, the flexibility of cobots means they can perform tasks like parts handling, assembly, and bin picking. Manufacturers adopting cobots, particularly those featuring vision and inspection systems, are seeing an increase in quality and efficiency. Investment Characteristics I hope we have convinced our readers that Robotics is a promising long-term investment theme. We also noted that the robotics ETFs are currently down substantially from their peaks. However, this report would not have been complete without a closer look at the investment characteristics of the robotics ETFs. A few salient points: Table 2Price Sensitivity The Robot Revolution The Robot Revolution Robotics ETFs have betas to the S&P 500 ranging from 1.2 to 1.4 (Table 2), which signals that the robotics sector is a high octane play on the US equity market. The recent pullback in the S&P 500 was particularly punishing for the stocks exposed to robotics. In terms of market capitalization, companies in this space tend to be smaller than the median company in the S&P 500, as they constitute the robotics ecosystem and supply chain (AI, Lidar), and tend to be younger and smaller. Robotics ETFs have always traded at a premium to the market given their superb growth potential. However, currently, ROBO ETF, which is a proxy for the rest of the cohort on a relative basis, is trading just under a half standard deviation above the historical mean (Chart 9). In terms of macroeconomic exposure, all of the robotics ETFs have a pronounced negative exposure to the US dollar – after all, robotics and automation are a global phenomenon. A stronger dollar makes American multinational sales from abroad lower both because of the translation effect and higher prices. The robotics theme doesn’t have much exposure to interest rates, inflation, or commodities, but is somewhat positively exposed to bitcoin (Table 3). Chart 9Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Table 3Robotics Is A High Octane Equities Theme With A Significant Sensitivity To USD The Robot Revolution The Robot Revolution Investment Implications Robotics is a compelling long-term investment theme as Industrial Revolution 4.0 is taking place in front of our eyes. And while over the short term, monetary tightening and slowing economic growth, both at home and abroad, will be a headwind; over time a new Google or Facebook may emerge in this space. We have already watched the success of Nvidia, a supplier of sophisticated chips for the industry. Table 4Comparing ETFs The Robot Revolution The Robot Revolution There are four ETFs that focus on Robotics and Automation (Table 4). BOTZ Is the largest ETF with $2.1 billion AUM, followed by ROBO at $1.7 billion, which is also the most expensive (Table A1 in the Appendix) Which one is the best? To answer this question, we have turned to the quant wizards at the BCA Equity Analyzer team. To compare the ETFs, they have assigned a BCA stock selection and Owl Analytics ESG scores to stocks in each of the robotics ETFs, to calculate composites.  We note the BCA composite score is low across the board, as robotics as a nascent investment theme scores low on valuations. We note that while ESG scores are comparable across the portfolios, there is some variation in BCA scores. Overall, ROBO is marginally better than the other options: It has the highest BCA score and is the most liquid. It also has a lower beta to the S&P 500 than BOTZ and IRBO, making it slightly less risky. Unfortunately, it is also the most expensive.  Bottom Line Robotics is an exciting long-term theme that benefits from multiple tailwinds, such as demographic trends, continuous technological innovation, reshoring, and customization. Robots are also becoming more intelligent and dexterous, and have better “senses,” making them suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. And that is a future from which investors should certainly profit.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix Table A1ETF Universe The Robot Revolution The Robot Revolution Footnotes 1     Clive Cookson in London, "Ouch! Robotic hand with smart skin recoils when jabbed in the palm,”  Financial Times, June 1, 2022, ft.com 2     Ron Jefferson, "Deep Learning Robot with Fine Motor Skills Peel Bananas Without Crushing the Fruit,”  Science Times, March 29, 2022, sciencetimes.com 3     "Is Lidar Going to be Replaced by Machine Vision?”  LiDAR News, January 12, 2022, blog.lidarnews.com 4     Jennifer Stowe, "Automation‌ ‌and‌ ‌IoT‌‌: ‌Transforming‌ ‌How‌ ‌Industries‌ ‌Function‌‌,”  IoT For All, October 12, 2020, iotforall.com Recommended Allocation Recommended Allocation: Addendum The Robot Revolution The Robot Revolution

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels ...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation Conversation With A Concerned Client: On Inflation 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations