US Dollar

Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded.  Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1  If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics.  In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? King Dollar Breaking Out? King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective.  Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries.  Chart 2Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield.   Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome.  A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014.  French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified.  Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat.  Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States.   Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless.   Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive.   Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap Emerging Market Bull Trap Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1  “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Image Section II: Appendix: 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 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 China’s slowdown will deepen, and US bond yields will likely rise. This augurs well for the US dollar but will produce a toxic cocktail for EM. The recent weakness in the commodity complex will continue. EM markets are at risk in absolute terms and will continue to underperform their DM counterparts. From a global macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. Feature Chart 1DXY Breakout, EM FX Breakdown DXY Breakout, EM FX Breakdown DXY Breakout, EM FX Breakdown The US dollar is breaking out and EM currencies are breaking down (Chart 1). This will set in motion a number of responses in global financial markets. These include but are not limited to selloffs in EM equities, domestic bonds and EM credit markets and a setback in the commodity complex. Hence, we reiterate our negative stance on EM stocks and fixed-income markets. We continue to recommend shorting a basket of EM currencies versus the US dollar. Please refer to the end of this report for detailed investment recommendations. Why The Greenback Is Set To Strengthen Since early in the year, our investment strategy has been based on two macro themes: China’s slowdown and rising US inflation. We concluded early on that these dynamics are positive for the US dollar. Both macro themes have played out fairly well, yet until recently the broad trade-weighted US dollar’s advance has been hesitant. Odds are that the rally in the greenback is about to accelerate. Chart 2China's Slowdown = US Dollar Rally China's Slowdown = US Dollar Rally China's Slowdown = US Dollar Rally The fundamental case for the US dollar rally remains as follows: China’s slowdown will weigh more on emerging Asia, Japan, Europe, and/or commodity producing, developing and developed economies than it will on the US. The basis is that US exports to China make up only 0.7% of its GDP. The same ratio is much higher for the rest of the world. Hence, the US economy will outperform many advanced and emerging economies. Chart 2 illustrates that, historically, whenever China has slowed down, the US dollar has rallied. The mainland’s property construction is shrinking, and traditional infrastructure investment is also extremely weak (Chart 3). Beijing is easing its regulatory and macro policies but only by degrees. For now, policy support will be insufficient to reverse the business cycle downturn. In the meantime, the US economy is overheating. Specifically, all core type inflation measures have surged to well above 2% (Chart 4). Critically, nominal wages are rising at the fastest rate seen in the past 35 years (Chart 5). Chart 3China: Infrastructure Investment Is Very Weak China: Infrastructure Investment Is Very Weak China: Infrastructure Investment Is Very Weak Chart 4US Core Inflation Is Broad-Based And High US Core Inflation Is Broad-Based And High US Core Inflation Is Broad-Based And High Given that the employee quit rate is very high, employers will have to grant notable wage increases to both new and current employees. Thus, wage growth will accelerate further. Recent wage gains have not been offset by productivity growth. As a result, unit labor costs are rising (Chart 6). This will push businesses to raise their selling prices. So long as household income and consumption remain robust, businesses will likely succeed in raising their prices. In short, US inflation is acute and genuine, and, hence, it will persist unless the economy slows considerably. Chart 5US Nominal Wage Growth Is At Its Fastest In 35 Years US Nominal Wage Growth Is At Its Fastest In 35 Years US Nominal Wage Growth Is At Its Fastest In 35 Years Chart 6US Unit Labor Costs Are Rising Fast US Unit Labor Costs Are Rising Fast US Unit Labor Costs Are Rising Fast The rise in US inflation will initially be bullish for the US dollar. The reason is that fixed-income markets will move to price in higher Fed funds rates and the Fed will also acknowledge the need to hike rates given that core inflation is well above its target range. At some point in future, however, high inflation will start hurting the US dollar. This will happen when the Fed eschews rate hikes and falls behind the inflation curve. We believe we are still in a window where US bond yields could rise further. Rising US interest rates will support the dollar. Finally, the US economy, but not necessarily its equity and credit markets, is better positioned to handle central bank tightening than are other DM and EM economies. American consumers have substantially deleveraged and there are shortages in US housing and cars. Even as US borrowing costs rise, interest rate sensitive sectors like housing and autos will still do well because of pent-up demand. In particular, the US housing market is sensitive to long-term (30-year) mortgage rates and not the front end of curve. On the contrary, many EM and other DM economies and their housing sectors are sensitive to domestic short-term rates. In percentage terms, the rise in US mortgage rates will likely be smaller than those in DM and EM economies. In short, the US economy will not slow sharply in the response to rates while EM and other DM economies will. This augurs well for the dollar. The key US vulnerability from higher interest rates stems from its equity and credit markets, not the real economy. US equities and credit markets are very richly priced, so the rising cost of capital could trigger a major selloff. In turn, wealth effects and tightening financial conditions will pose a risk to the real economy. However, even in this case, the US dollar will initially appreciate because it always rallies during risk-off phases. The greenback’s depreciation will resume when the Fed turns dovish again. From a big picture macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. In this period of US dollar strength, EM financial markets will be hurt because foreign investors always flee EM when their currencies depreciate. Bottom Line: China’s slowdown will deepen, and US bond yields will likely rise. This will produce a toxic cocktail for EM. Watch Out Commodity Prices Chart 7Reduced Financing For Property Developers = Less Construction Reduced Financing For Property Developers = Less Construction Reduced Financing For Property Developers = Less Construction The downturns in China’s property construction and traditional infrastructure spending are bad for raw material prices. The following points offer an explanation as to why commodity prices will relapse in spite of the fact that they have thus far resisted China’s slowdown. Although Chinese property sales and starts have been shrinking, floor area completed (construction work) has been very strong. However, the liquidity crunch that many real estate developers are experiencing will lead them to halt or cut back on their construction work (Chart 7, top panel). The latter will weigh on raw material prices (Chart 7, bottom panel). Taiwan’s new export orders PMI for the basic materials sector has dropped below 50, indicating plunging regional demand for raw materials (Chart 8). Ongoing weakness in Chinese demand is the culprit behind this drop. Due to electricity shortages, mainland production of industrial metals has plunged (Chart 9, top panel). Yet, the prices of these metals have recently corrected (Chart 9, bottom panel). Falling prices amid shrinking supply are a sign of major demand relapse. Chart 8Greater China: Orders For Basic Materials Are Already Shrinking Greater China: Orders For Basic Materials Are Already Shrinking Greater China: Orders For Basic Materials Are Already Shrinking Chart 9Base Metal Price Falling Despite Production Shutdowns In China Base Metal Price Falling Despite Production Shutdowns In China Base Metal Price Falling Despite Production Shutdowns In China   The Baltic Dry index – the price of shipping bulk commodities – has rolled over decisively. It has reasonable correlation with industrial metal prices. Oil is much less exposed than base metals to China’s property and infrastructure contraction. In the case of crude, the key risks are the US and China releasing their strategic reserves and the US dollar strength. Bottom Line: The recent weakness in the commodity complex will continue. Other Considerations Chart 10China's Onshore Stock-to_Bond Ratio Is Breaking Down China's Onshore Stock-to_Bond Ratio Is Breaking Down China's Onshore Stock-to_Bond Ratio Is Breaking Down There are a number of other considerations and indicators that lead us to maintain a negative stance on EM financial markets: China’s onshore stock-to-bond ratio has broken below its 200-day moving average (Chart 10). This signifies a deepening growth slump in China. EM equity underperformance has been broad-based. Both the market cap-weighted and equal-weighted EM equity indexes have been underperforming their respective DM indexes. Further, not only have TMT (technology, media and telecom) stocks been underperforming their DM peers, but non-TMT stocks have also lagged their counterparts substantially (Chart 11). Last but not least, EM TMT stocks remain at risk. First, share prices of Chinese internet companies will continue derating due to structurally lower profitability going forward as the government exercises more control over them. We have discussed this in previous reports. In addition, consumer spending online has slowed sharply while smartphone sales are plunging (Chart 12). Chart 11EM Equity Underperformance Is Broad-Based EM Equity Underperformance Is Broad-Based EM Equity Underperformance Is Broad-Based Chart 12China: Online Spending Is Very Weak China: Online Spending Is Very Weak China: Online Spending Is Very Weak Second, DRAM (memory chip) prices are deflating and the value of DRAM sales is shrinking (Chart 13). This is weighing on Korean semiconductor share prices like Samsung and SK Hynix. These stocks have a large market cap in the KOSPI index. Finally, demand for semiconductors produced by Taiwanese companies has been booming but it is presently showing signs of moderation (Chart 14). Chart 13Falling DRAM Prices Are Weighing On Korean Semi Stocks Falling DRAM Prices Are Weighing On Korean Semi Stocks Falling DRAM Prices Are Weighing On Korean Semi Stocks Chart 14Taiwanese Semiconductor Industry: Moderating Orders Taiwanese Semiconductor Industry: Moderating Orders Taiwanese Semiconductor Industry: Moderating Orders Importantly, geopolitical risks around Taiwan in general and TSMC in particularly are enormous. The latter is literally at the center of the US-China confrontation. The timing of a diplomatic or even military crisis is uncertain but our Geopolitical Strategy team expects geopolitical risks over Taiwan to escalate substantially. The recent summit between Presidents Joe Biden and Xi Jinping does not change this assessment.  Investment Recommendations Chart 15EM Credit Markets: Prepare For A Broad Selloff EM Credit Markets: Prepare For A Broad Selloff EM Credit Markets: Prepare For A Broad Selloff Continue underweighting EM equities in a global equity portfolio. Within the EM space, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Concerning EM equity sectors, we reiterate the short EM banks / long DM banks and short EM banks / long EM consumer staples positions. In line with our US dollar breakout thesis, we continue to recommend a short position in a basket of the following EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, TRY, THB, PHP and KRW. EM exchange rate depreciation is bad for EM domestic bonds. Currency weakness could lead central banks in Latin America to hike rates further. In brief, the risk-reward of EM local currency bonds is still unattractive. In this space, we recommend the following positions: bet on yield curve flattening in Mexico and Russia (pay 1-year/receive 10-year swap rates); pay Czech 10-year swap rates; receive Chinese and Malaysian 10-year swap rates. We reiterate our underweight in EM credit (both sovereign and corporate) markets versus US corporate credit, quality adjusted. As EM exchange rates depreciate, EM credit spreads will widen (Chart 15). Chinese high-yield corporate US dollar bonds are not yet a buy because the mainland property market’s travails are far from over, as was discussed in our recent Special Report. For a complete list of our recommendations across all asset classes and country strategy within each asset class, please see below or visit our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2   Chart I-7The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. 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 US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Revolving Credit On The Rise Again Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 8 Chart 9The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   Chart 10 The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 11 Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. Chart 14 In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas Chart 16 In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Dear client, This week, we are introducing our new “Currency Month-In-Review” report. The new format should dovetail nicely with the historical back sections you have become accustomed to, but with a more holistic approach to interpreting data releases, along with actionable investment advice. We would appreciate any comments, criticisms, and feedback to help us better serve you. Kind regards, The Foreign Exchange Strategy team   Highlights The DXY index has broken above our 95-threshold level. As a momentum currency, the prospect for further gains in the near term are high. That said, we are sticking with our longer-term (12-18 month) bearish view. Most of the catalysts propping the dollar in the near-term should reverse. The Fed will continue to lag the inflation curve, and economic growth will rotate from the US to other economies that are getting their populations vaccinated. Both are dollar bearish. Speculative positioning in the dollar is now approaching extremes. This warns against establishing fresh long positions. Amidst the volatility in currency markets, trading opportunities are emerging. This week, we are initiating a limit-buy on EUR/CHF trade at 1.05. Feature The latest CPI report from the US was strong, taking markets much by surprise. In the currency world, the spread between the 3-month Eurodollar and Euribor interest rate shot up, pushing up the dollar (Chart 1). December 2022 Eurodollar futures are now pricing in a much faster pace of rate hikes than they did earlier this year. This helped cement the dollar as king this year (Chart 2). Chart 1The Dollar And Interest Rates The Dollar And Interest Rates The Dollar And Interest Rates Chart 2AThe Strength In The DXY Is Not Fully Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture Chart 2BThe Strength In The DXY Is Not Fully Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture Chart 2CThe Strength In The DXY Is Not Fully Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture Chart 2DThe Strength In The DXY Is Not Fully Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture The Strength In The DXY Is Justified By The Economic Picture Economic data has also been moving in favor of the US of late. The economic surprise index in the US is at 19, while in the eurozone and Japan, it is at -50 and -73.9, respectively. From a broader perspective, the recovery in the services PMI in the US had been more robust than most other developed economies. That said, there are also signs that US economic momentum is giving way to other countries. The US is likely to be the first country to close its output gap, and commensurately, inflation is surprising to the upside (Chart 3). Wage growth has also inflected higher. This is raising the prospect that inflation might be more of a genuine concern. For many other countries, surging house prices are threatening financial stability. In New Zealand, the central bank now has a mandate to consider house prices when calibrating policy. Chart 3AThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3BThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3CThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3DThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates The US Is Generating Genuine Inflation. This Is Depressing Real Rates The key point is that many central banks have already withdrawn accommodation ahead of the Fed, which puts the recent dollar rally into question. QE has ended in Canada and New Zealand. Norway and New Zealand have hiked interest rates. Forward curves suggest that most central banks should continue to withdraw accommodation. The key question is whether the Fed turns more hawkish that what is already priced in, or disappoints market expectations. We side with the latter. In the meantime, real rates continue to remain deeply negative in the US. With negative real rates and a deteriorating trade balance, the US will need to significantly raise interest rates to attract portfolio investment. For the US, portfolio investment has mostly been in the form of equity purchases rather than bond flows (Chart 4) and Chart 5). But even an increase in the US 10-year yield to 2.25% will keep real interest rates low. In the following sections, we look at the latest economic releases and provide our assessment of the impact going forward on various currencies. Chart 4AThe Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations Chart 4BThe Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations Chart 4CThe Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations The Fed Could Disappoint Market Expectations Chart 4 Chart 5AThe US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally Chart 5BThe US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally Chart 5CThe US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally Chart 5DThe US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally The US Trade Deficit Needs To Be Financed Externally US Dollar The last month has seen US economic data outperform that of its peers. Within the G10, the Citigroup economic surprise index is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). This has supported the DXY, which is up almost 1% over the last month. For risk-management purposes, we are turning neutral on the DXY in the near term, even though our longer-term view remains bearish. The two most important releases in the US over the last month were the jobs report and this week’s CPI report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October. This is inching closer to NAIRU. Meanwhile, headline CPI came in at 6.2% year-on-year in September while core inflation came in at 4.9%, the highest for several decades. This is occurring within the context of accelerating wage growth (unit labor costs in the nonfarm business sector surged 8.3% in Q3), higher house prices, and an ebullient stock market, reinforcing the wealth effect.  That said, strong domestic demand in the US will have to trigger a much more hawkish Fed for the dollar to reach escape velocity. This is because it will push real interest rates lower as it inflates the US current account deficit. The trade deficit grew 11.2% in September, the sharpest monthly increase since July of 2020. Equity portfolio flows, which have been sustaining the trade deficit, are softening of late. Bond portfolio flows will need a much weaker dollar, or higher Treasury yields, to accelerate. Against such a backdrop, the Fed recently announced a “dovish taper” by reducing the monthly pace of its asset purchases by $15 billion, with the tapering expected to be completed by mid-2022. No imminent rate hike was signaled. The market is likely to continue to challenge such a dovish stance, which will put near-term upward pressure on the dollar, until inflation eventually rolls over. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy. We are sticking to our long-term bearish view on the dollar index, but a more proactive Fed is a risk to this view. We are upgrading our near-term outlook on the dollar to neutral.  Chart 6AUS Dollar US Dollar US Dollar Chart 6BUS Dollar US Dollar US Dollar Euro The euro has been breaking down in recent sessions and is the main cause of the surge in the DXY index. The euro is down 0.7% over the last month and is currently at 1.145. The key catalyst for the weakness in the euro is the perception that the ECB will severely lag the Fed in normalizing policy settings. This is occurring within the context of surging inflation in the euro area. Headline CPI came in at 4.1% in October, above expectations of 3.7% and well above September’s 3.4% print. The is dampening real rates in the entire eurozone. On the flip side, there is credence to the ECB’s dovish stance given that unemployment is still above NAIRU and eurozone wage growth remains very tepid. On the economy, the recent improvement in both the Sentix and ZEW expectations bode well for euro area activity.  Lower real rates have been the proximate driver of a soft euro in recent trading sessions. That said, real rates could improve if inflation proves transitory. The energy component of the CPI was up 23% year-on-year, by far the biggest contributor to the headline print. Any sign that the ECB is tilting towards a more hawkish direction will initially materialize in the form of reduced asset purchases. This would curtail the significant portfolio outflows from the eurozone this year. From a positioning standpoint, speculative long positions in the euro have also been liquidated, which provides some footing for the currency. We are maintaining a neutral stance on the euro in the very near term, with a bias to buy on weakness.  Chart 7AEuro Euro Euro Chart 7BEuro Euro Euro   Japanese  Yen JPY is the worst-performing currency this year and it is also one of the most shorted. Over the last month, the yen is down 0.4%. Japan is just now emerging from the pandemic, having vaccinated most of its population. Ergo, the economic surprise index, which currently sits at -74, could stage a powerful rebound. While both the inflation print and employment data were in line with expectations (the unemployment rate came in at 2.8% in September), there were other encouraging signs. In October, the Eco Watcher’s Survey rose from 42.1 to 55.5, the manufacturing PMI rose from 51.5 to 53.2, and machine tool orders accelerated 81.5% year-on-year.  The Bank of Japan kept monetary policy unchanged at its latest meeting. The policy stance of the BoJ remains dovish, with little prospect of any interest rate increase until 2025. Therefore, in an environment where interest rates rise, that will hurt the yen at the margin. That said, the underperformance of Japanese assets is attracting portfolio inflows, especially from equity investors. As we wrote last week, the underperformance of certain Japanese equity sectors has not been fully justified by the improving earnings picture. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and it is also quite cheap according to our intermediate-term timing model. Therefore, even given the breakout in the DXY index, we are maintaining our near-term positive for the yen. Chart 8AJapanese Yen Japanese Yen Japanese Yen Chart 8BJapanese Yen Japanese Yen Japanese Yen British Pound As a high-beta currency, sterling has been one of the victims of dollar strength. GBP is down 1.6% over the last month. The biggest driver was the volte-face from the BoE. The BoE kept rates on hold despite their seemingly hawkish messaging weeks ahead of the MPC meeting. Gilt yields fell along with the pound. Following the expiry of the furlough scheme in September, the central bank is waiting to the see the potential impact on the labor market before curtailing accommodation. Hence, a hike in December is still on the table. Incoming data continues to strengthen the case for the BoE to tighten policy. CPI is at 3.5%, with the transport and housing sectors continuing to see surging prices. At 4.5%, the unemployment rate is at NAIRU. Wages are also inflecting higher. The latest GDP report (Q3 GDP rose 6.6% year-on-year) continues to suggest the UK economy maintains upward momentum. The October manufacturing PMI rose from 57.1 to 57.8.  Near term, the pound could continue to face weakness as speculators liquidate positions and capital inflows soften. This is especially the case as the post-Brexit environment remains quite volatile. As a play on this trend, we are tactically long EUR/GBP. However, we remain bullish sterling on a cyclical horizon as real rates should continue to normalize. Chart 9ABritish Pound British Pound British Pound Chart 9BBritish Pound British Pound British Pound Australian Dollar The Australian dollar is down 0.8% over the last month, as both a stronger dollar and lower iron ore prices exert downward pressure on the exchange rate. The biggest developments over the last few weeks in Australia were the CPI report and the RBA policy meeting. The Q3 print for CPI was 3%, the upper bound of the central bank’s target range, with the trimmed-mean and weighted-median figure coming in at 2.1%. This helped justify the RBA’s decision to abandon the 0.1% yield target on the April 2024 bond. That said, the central bank maintained its cash rate target of 0.1% until earliest 2023 and left the pace of asset purchases unchanged. The RBA trimmed its forecast for GDP for this year to 3% from 4% and said more than 50% of jobs were currently experiencing little to no wage growth. Wages grew just 1.7% in the year to June, far below the 3%-plus levels the RBA believes is necessary to keep inflation sustainably within the 2%-3% band and trigger a rate hike. Hence, the release of the Q3 wage price index, on November 17, will be closely watched. Any upward surprise can challenge the RBA’s measured projections. The bearish case for the Aussie is well known, with speculative positioning near a record short. That said, real yields in Australia have been improving and portfolio flows are accelerating, especially into the mining and energy sectors, which are benefiting from a terms-of-trade tailwind. This sets the stage for a coil-spring rebound in the Aussie. 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. From a tactical standpoint, we are neutral the Aussie, but will buy outright at 70 cents.  Chart 10AAustralian Dollar Australian Dollar Australian Dollar Chart 10BAustralian Dollar Australia Dollar Australia Dollar New Zealand Dollar The New Zealand dollar is up 1.3% over the last month. New Zealand’s economy is firing on all cylinders. CPI accelerated sharply from 3.3% to 4.9% in Q3, well above the RBNZ’s target band of 1%-3%, and behind only that of the US. The unemployment rate fell to 3.4% in Q3, far lower than the 3.9% forecasted by economists polled by Reuters. Wage growth was strong in the quarter with the private sector labor cost index registering a 0.7% lift. The seasonally adjusted employment number jumped 2.0% on the quarter, beating expectations of a 0.4% increase. The participation rate also rose to 71.2%, higher than the 70.6% forecast. Meanwhile, house prices continue to move higher, especially in Wellington.  As a result, the RBNZ has been one of the most hawkish G10 central banks, hiking rates last month for the first time in seven years to 0.5%. Another 0.25% hike is likely at the November 24 meeting. Meanwhile, at 2.6%, New Zealand currently has the highest G10 10-year bond yield. This is bullish for the kiwi. The one caveat is that the Covid-19 situation in New Zealand continues to deteriorate, which could be a catalyst for a pause.  Portfolio flows into New Zealand have turned negative in recent quarters. The equity market, which is quite expensive, has underperformed and the currency is overvalued according to our models, which has dampened the appeal of higher yields. 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.  Chart 11ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 11BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar The CAD is the best-performing currency this year, even though it is down 1% over the last month. The key driver of the CAD in recent weeks remains the outlook for monetary policy, and the path of energy prices. CPI inflation came in at 4.4% year-on-year for September, beating market expectations and among the highest across the G10. The CPI-trim hit 3.4% year-on-year. With all eight major components of the CPI rising year-over-year, upward price pressures are broad-based. The housing market also appears bubbly, all providing fertile ground for tighter monetary settings. At first blush, the October employment report was disappointing, with only 31,000 jobs added. However, employment in Canada is already above pre-pandemic levels and is likely to now settle towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs, in line with October’s release. The unemployment rate continues to drop, hitting 6.7%. Incoming data justified the Bank of Canada’s policy response. It delivered a hawkish surprise announcing an end to its quantitative easing program and shifting to the reinvestment phase whereby its holdings of Canadian government bonds will be held constant. It also brought forward the first rate hike to Q2 2022. The BoC will marginally diverge from the US Fed, which is expected to keep rates unchanged through most of next year. This will continue to boost real rates in Canada. Meanwhile, net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. That said, from a tactical standpoint, speculators are marginally long the CAD. As such, our near-term view is cautious. We however doubt the CAD will significantly break below 78 cents, given burgeoning tailwinds.  Chart 12ACanadian Dollar Canadian Dollar Canadian Dollar Chart 12BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc The Swiss franc is up 1% against the dollar over the last month. EUR/CHF has also been very weak in recent trading sessions, constantly testing the 1.054 level. In our view, this has been much more due to euro weakness (see euro section above) than franc strength. The Swiss franc is trading near 11-month highs versus the euro. On the economic front, the labor market is improving and inflation in Switzerland is picking up. House prices have also risen quite robustly. This is lessening the need for the central back to maintain ultra-accommodative settings.  That said, the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. This suggests that market pricing of a 25 basis-point rate rise by the SNB by the end of 2022 is misplaced. Inflation would have to rise substantially more - above the SNB's target range of less than 2% - before any hike is possible. The SNB has also said it remained ready to intervene to weaken a highly valued Swiss franc. The ECB’s dovish stance is one reason why the SNB will be loath to let the currency appreciate. Our guess is that the 1.05 level provides a near-term line in the sand, which will prompt the SNB to intervene. We would be buyers of EUR/CHF below 1.05.  Chart 13ASwiss Franc Swiss Franc Swiss Franc Chart 13BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone The Norwegian krone has violently sold off in recent weeks, prompting our long Scandinavian basket to be stopped out. This has been mostly due to low liquidity and the high-beta nature of the krone. Norway’s central bank kept interest rates on hold at its latest meeting but reiterated it will likely hike its key rate by 25 basis points to 0.5% in December. The central bank noted that the economic recovery pushed activity back to pre-pandemic levels, while unemployment receded further. That said, underlying inflation still runs below the bank’s target.  The recent surge in oil prices has provided strong support for Norway’s trade balance and terms of trade. Oil and gas make up around 18% of Norway’s GDP. This is encouraging portfolio flows and has provided underlying support for the NOK. That said, given that much of the Norges Bank’s hawkishness has likely been priced into the NOK, the rewards of going long the currency should start shifting to its carry.  Chart 14ANorwegian Krone Norwegian Krone Norwegian Krone Chart 14BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona The SEK was up 0.9% over the last month. Sweden never closed its economy, yet Covid-19 still had an impact. The good news is that this is mostly behind them. GDP expanded by 1.8% on the quarter in Q3, beating forecasts and the country recently ended all pandemic curbs. The labor market is recovering, and inflation is rising. CPIF inflation, on which the Riksbank sets its 2% target, is at 2.8%. Surging energy prices should turn out to be less of a problem for Sweden than the more coal-dependent countries in Europe, suggesting any increase in prices will be more genuine.  The Riksbank will complete its planned balance-sheet expansion later this year and has committed to maintaining the size of its bond holdings through 2022. The central bank, one of the most dovish amongst the G10, is slated to keep its policy rate flat at least until 2024. This could change if inflationary pressures remain persistent.  The big risk for Sweden is a slowdown in Europe and China. Supply chain bottlenecks are another issue. Several Swedish car and truck makers were forced to halt production in August due to semiconductor shortages. With the recent surge in the dollar, we were stopped out of our short EUR/SEK and USD/SEK positions for a profit. We will be looking to reinstate these trades from higher levels.  Chart 15ASwedish Krona Swedish Krona Swedish Krona Chart 15BSwedish Krona Swedish Krona Swedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Kate Sun Research Analyst kate.sun@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

In this report we examine the risk of stagflation by comparing the current environment to that of the late-1960s and 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part due to strong goods demand and supply disruptions that will eventually dissipate, and economic agents do not expect severe price pressures to persist beyond the pandemic. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not a likely event. Investors should use the Misery Index, which is the sum of the unemployment rate and headline PCE inflation, as a real-time stagflation indicator. The Misery Index underscores that the US economy is unlikely to experience true stagflation unless the unemployment rate rises. A portfolio of the US dollar, the Swiss Franc, and industrial commodities may serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-1The Misery Index Reflects The Risk Of Stagflation The Misery Index Reflects The Risk Of Stagflation The Misery Index Reflects The Risk Of Stagflation Over the past several weeks, concerns about a possible return to 1970s-style stagflation have re-emerged significantly in the minds of many investors. These investors have pointed toward similarities between the current environment and that of the 1970s, including shortages limiting output, a snarled global trade and logistical system, and rising energy prices. Chart II-1 highlights that the US “Misery Index” – the sum of the unemployment rate and headline PCE inflation – rose again over the past several months to high single-digit territory, after having fallen dramatically from April 2020 to February of this year. Panel 2 of Chart II-1 highlights that last year's rise in the Misery Index was driven almost entirely by the unemployment rate, whereas the current level is due to a combination of a modestly elevated unemployment rate and a pronounced acceleration in inflation. The headline PCE deflator has risen above 4%, a level that has not been reached since 1991 during the First Gulf War. In this report, we examine the risk of stagflation by comparing the current environment to that of the late 1960s and 1970s. We conclude that while investors cannot rule out the possibility of a stagflationary outcome, there are important differences that point toward a stagflation outcome over the coming 6-24 months as a risk, not a likely event. We conclude by highlighting assets that may produce absolute returns in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Revisiting The 1960s And 70s Chart II-2The 1960s Laid The Groundwork For Elevated Inflation The 1960s Laid The Groundwork For Elevated Inflation The 1960s Laid The Groundwork For Elevated Inflation The first step in judging the risk of a return to 1970s-style stagflation is to review, in a detailed way, what caused those conditions. Investors are well aware of the role that two separate energy price shocks played in raising prices and damaging output during this period, but they are less cognizant of the impact that a persistent period of above-trend output and significant labor market tightness had in setting up the conditions for sharply higher inflation. This focus of investors on energy prices partially reflects the fact that the Misery Index increased most visibly in the 1970s and that policymakers in the 1960s may not have realized how extensively economic output was running above its potential. With the benefit of hindsight, Chart II-2 illustrates the extent to which inflationary pressures built up in the 1960s, well before the first oil price shock in 1973. The chart shows that the unemployment rate was below NAIRU – the non-accelerating inflation rate of unemployment – for 70% of the time during the 1960s, and that inflation had already responded to this in the latter half of the decade. Annual headline PCE inflation was running just shy of 5% at the onset of the 1970 recession; it fell to 3% in the aftermath of the recession, but had already begun to reaccelerate in the first half of 1973. Following the 1973/1974 recession, inflation did decelerate significantly, falling from 11-12% to 5% in headline terms, and from 10% to 6% in core terms. But the pace of price appreciation did not fall below 5-6% in the second half of the 1970s, despite a significant and sustained rise in the unemployment rate above its natural rate. The 1975 to 1978 period is especially important for investors to understand, because it is arguably the clearest period of true stagflation in the 1970s. The fact that the Misery Index rose sharply during two major oil price shocks is not particularly surprising in and of itself, given the direct impact of energy prices on headline consumer prices; it is the fact that the index remained so elevated between these shocks, the result of persistently high inflation in the face of significant labor market slack, that is most relevant to investors. There are two reasons that both inflation and unemployment remained high during this period. First, labor market slack was sizeable during these years because the US economy was more energy-intensive in the 1970s than it is today. Chart II-3 highlights that goods-producing employment lagged overall employment growth from late 1973 to late 1977, underscoring that the rise in oil prices significantly impacted jobs growth in energy-intensive industries. Chart II-3 Second, it is clear that the combination of demand-pull inflation in the late 1960s and the predominantly cost-push inflation of the 1970s led to expectations of persistent inflation among households and firms. The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. But the experience of the 1970s highlighted that inflation expectations are also an important determinant of inflation, a realization that gave birth to the expectations-augmented (i.e. “modern-day”) Phillips Curve (more on this below). The Stagflation Era Versus Today Chart II- Table II-1 presents a stagflation “threat matrix,” representing the Bank Credit Analyst service’s assessment of the various factors that could potentially contribute to a stagflationary environment today, relative to what occurred in the 1960s and 1970s. While we acknowledge that there are some similarities today to what occurred five decades ago, the most threatening factors have been present for a shorter period of time and appear to have a smaller magnitude than what occurred during the stagflationary era. In addition, key factors, such as the visibility available to policymakers and investors about household inflation expectations and the potential output of the economy, would appear to reduce significantly the risk of a stagflationary outcome today. We discuss each of the factors presented in Table II-1 below: Fiscal & Monetary Policy Chart II-4Government Spending Last Cycle Looked Nothing Like The 1960s Government Spending Last Cycle Looked Nothing Like The 1960s Government Spending Last Cycle Looked Nothing Like The 1960s The persistently tight labor market that contributed to the inflationary buildup in the 1960s occurred as a result of easy fiscal and monetary policy. Chart II-4 highlights that the contribution to real GDP growth from government expenditure and investment was very elevated in the 1960s. Chart II-5 shows that a positive output gap in the late 1960s and the first half of the 1970s is well explained by the fact that 10-year US government bond yields were persistently below nominal GDP growth. The relationship between the stance of monetary policy and the output gap only meaningfully diverged in the latter half of the 1970s, during the true stagflationary era that we noted above. Chart II-5Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Chart II-6Monetary Policy Today Is Extremely Easy Monetary Policy Today Is Extremely Easy Monetary Policy Today Is Extremely Easy Today, it is clear that the stance of fiscal policy has recently been extraordinarily easy, and 10-year US government bond yields have remained well below nominal GDP growth for the better part of the last decade. Relative to estimates of potential nominal GDP growth, 10-year Treasury yields are the lowest they have been since the 1970s (Chart II-6). Ostensibly, this supports concerns that policy might contribute to a stagflationary outcome. These concerns were raised by Larry Summers in March, when he described the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 But there are two important counterpoints to these concerns. First, easy fiscal policy this cycle has followed a period during the last economic cycle in which government spending contributed to the most sustained drag on economic activity since the 1950s. Unlike the 1960s, the unemployment rate has been below NAIRU for only a third of the time over the past decade. In addition, Chart II-7 highlights that fiscal thrust will turn to fiscal drag next year, underscoring the temporary nature of the massive burst in fiscal spending that has occurred in response to the pandemic. Under normal circumstances, the fiscal drag implied by Chart II-7 would substantially raise the risks of a recession next year, but we have noted in previous reports that a significant amount of excess savings remain to support spending and employment. The net impact of these two factors results in a reasonable expectation that the US economy will return to maximum employment next year, but this is a far cry from the 1960s when the unemployment rate was below its natural rate for 70% of the decade. Chart II-7 Based on conventional measures, US monetary policy has been easy for a decade, but easy monetary policy did not begin to contribute positively to a rise in household sector credit growth last cycle until 2014/2015. This underscores that the natural rate of interest (“R-star”) did fall during the early phase of the last economic expansion. However, we argued in an April report that R-star was likely rising in the latter half of the last expansion,2 and we believe that the terminal Fed funds rate is likely higher than what the Fed is currently projecting, barring any additional negative policy shocks. Thus, while we do not believe that the duration of easy monetary policy over the past decade has laid the groundwork for a major rise in prices, it is now clearly positively contributing to aggregate demand and does risk a future overshoot in prices if long maturity bond yields remain well below the pace of economic growth for a sustained period of time. The Impact Of Shortages Chart II-8Gasoline Shortages Plagued The US Economy In The 1970s Gasoline Shortages Plagued The US Economy In The 1970s Gasoline Shortages Plagued The US Economy In The 1970s Gasoline shortages occurred during the oil shocks of the 1970s and are a key similarity that some investors point toward when comparing the situation today with the stagflationary era. Chart II-8 highlights that the annual growth in real personal consumption expenditures on energy goods and services fell into negative territory on six occasions in the 1970s, although it was most pronounced during the two oil price shocks and their resulting recessions. Today, the impact of shortages appears to be broader than what occurred in the 1970s, but less impactful and not likely to be as long-lasting. Chart II-9 highlights that the OPEC oil embargo of 1973 raised the global oil bill by 2.4% of global GDP and permanently raised the price of oil. The global oil bill will only be fractionally above its pre-pandemic level in 2022, with oil prices at $80/bbl, and, while it is true that US gasoline prices have risen significantly, they are not higher than they were from 2011-2014 (Chart II-10). Chart II-9$80/bbl Oil Is Not Onerous $80/bbl Oil Is Not Onerous $80/bbl Oil Is Not Onerous Chart II-10US Gasoline Prices Are High, But They Have Been Higher US Gasoline Prices Are High, But They Have Been Higher US Gasoline Prices Are High, But They Have Been Higher It is certainly true that global shipping costs have skyrocketed and that this is contributing to the increase in US consumer prices. We estimate, however, that this increase in shipping costs as a share of GDP is no more than a quarter of the impact of the 1973 increase in oil prices, without the attendant negative effects on US goods-producing employment that occurred in the 1970s. If anything, surging shipping costs create an incentive to re-shore manufacturing production, which would contribute positively to US goods-producing employment. We also do not expect the rise in shipping costs to be meaningfully permanent, i.e., shipping costs may ultimately settle at a higher level than they were in late-2019, but at a much lower level than what prevails today. Chart II-11A Tight Labor Market Is Causing Wage Growth To Pick Up A Tight Labor Market Is Causing Wage Growth To Pick Up A Tight Labor Market Is Causing Wage Growth To Pick Up Semiconductor and labor shortages would appear to represent a more salient threat of stagflation in the US, as the domestic production of motor vehicles cannot occur without key inputs and a tight labor market is already contributing to an acceleration in wage growth (Chart II-11). As we noted in Section 1 of our report, auto production significantly impacted growth in the third quarter. However, Chart II-12 highlights that, for now, the breadth of impact of these shortages appears to be limited: the production component of the ISM manufacturing index remains in expansionary territory, industrial production of durable manufacturing excluding motor vehicles and parts has not broken down, and both housing starts and building permits remain above pre-pandemic levels despite this year’s downtrend in permits. Chart II-12Shortages Do Not Yet Seem To Be Broad-Based Shortages Do Not Yet Seem To Be Broad-Based Shortages Do Not Yet Seem To Be Broad-Based A physical shortage of components is a less relevant factor for the services side of the economy, which appears to have re-accelerated meaningfully in October. The services sector is more considerably impacted by shortages in the labor market, which seem to be linked to a still-low labor force participation rate. We noted in our September report that the decline in the participation rate has significantly overshot what would be implied by the ongoing pace of retirements. Chart II-13 highlights that this has occurred not just because of a significant retirement effect, but also because of the shadow labor force (people who want a job but are not currently looking for work) and family responsibilities. We expect that the recent expiry of expanded unemployment insurance benefits, a steady rise in the immunity of the US population, an abating Delta wave of COVID-19, and a likely upcoming reduction in school/classroom closures once the Pfizer/BioNTech vaccine is approved for school-age children will likely ease the labor shortage issue over the coming several months. Chart II-13 Output Gap Uncertainty It remains a debate among economists why policymakers maintained such easy monetary policy in the 1960s and 1970s, but Chart II-14 highlights that uncertainty about the size of the output gap may have contributed to too-low interest rates. The chart shows the unemployment rate compared with today's estimate of NAIRU, alongside a simple proxy for policymakers’ real time estimate of the natural rate of employment: the cumulative average unemployment rate in the post-war environment. To the extent that policymakers used past averages of the unemployment rate as their guide for NAIRU, Chart II-14 highlights how they may have underestimated the degree to which output was running above its potential level in the 1960s, and would not have even concluded that output was above potential in the early 1970s. Chart II-14Policymakers Overestimated Labor Market Slack In The 60s And 70s Policymakers Overestimated Labor Market Slack In The 60s And 70s Policymakers Overestimated Labor Market Slack In The 60s And 70s Chart II-15Policymakers Know That NAIRU Is Likely At Or Below 4% Policymakers Know That NAIRU Is Likely At Or Below 4% Policymakers Know That NAIRU Is Likely At Or Below 4% Today, the environment is quite different, because the acceleration in wage growth at the tail end of the last expansion gives policymakers and investors a good estimate of where NAIRU is. Chart II-15 highlights that wage growth accelerated in 2018/2019 in response to a sub-4% unemployment rate, which is consistent with both the Fed’s NAIRU estimate of 3.5-4.5% and Fed Vice Chair Richard Clarida’s expressed view that a 3.8% unemployment rate likely constitutes maximum employment (barring any issues with the breadth and inclusivity of the labor market recovery). It is possible that the pandemic has structurally lowered potential output, which could mean that policymakers may no longer rely on the wage growth / unemployment relationship that existed in the latter phase of the last expansion. However, we do not find any credible arguments that would support the notion of a structurally lower level of potential output: the pandemic is likely to end at some point in the not-too-distant future, the negative impact of working-from-home policies on office properties and employment in central business districts is not sizeable,3 and productivity may have permanently increased in some industries because of the likely stickiness of a hybrid work culture. The Behavior Of Inflation Expectations Chart II-16Rising Long-Term Expectations Have Merely Normalized (For Now) Rising Long-Term Expectations Have Merely Normalized (For Now) Rising Long-Term Expectations Have Merely Normalized (For Now) One parallel to the argument that policymakers may have underestimated the degree of labor market tightness in the 1960s and early 1970s is the fact that they did not yet understand that inflation expectations are an important determinant of actual inflation, nor were they able to monitor them even if they did. Most credible surveys of inflation expectations began in the 1980s, and policymakers in the 1960s and 1970s were guided by the original Phillips Curve that solely related inflation to unemployment. Today, policymakers have the experience of the stagflationary episode to serve as a warning not to allow inflation expectations to get out of control, and both policymakers and investors have reliable measures of inflation expectations for households and market-participants. Chart II-16 highlights that households expect significant inflation over the coming year, but also expect prices over the longer term to rise at a pace that is almost exactly in line with their average from 2000-2014. The Rudd Controversy: (Adaptive) Inflation Expectations Do Matter One potential criticism of the idea that inflation expectations are signaling a low risk of higher future inflation has emerged through arguments made by Jeremy Rudd, a Federal Reserve economist. In a recent paper, Rudd questioned the view that households’ and firms’ expectations of future inflation are a key determinant of actual inflation; he suggested instead that relatively stable inflation since the mid-1990s might reflect a situation in which inflation simply does not enter workers’ employment decisions and expectations are irrelevant. Rudd’s paper was primarily addressed to policymakers who view inflation dynamics in a highly quantitative light. A full response to the paper would be mostly academic and thus not especially relevant to investors; however, we would like to highlight three points related to the Rudd piece that we feel are important.4 First, we disagree with Rudd’s argument that the trend in inflation has not responded to changes in economic conditions since the mid-1990s. Chart II-17 highlights that while the magnitude of the relationship has shifted, the trend in inflation relative to a measure of long-term expectations based on prior actual inflation has mimicked that of the output gap. The fact that inflation was (ironically) too high during the early phase of the last economic cycle provides some support for Rudd’s inflation responsiveness view, although we would still point toward the Fed’s strong record of maintaining low and stable inflation, its active communication with the public in the years following the global financial crisis, and the fact that a recovery began and the output gap began to (slowly) close as the best explanation for the avoidance of deflation during that period. Second, we agree with Rudd’s point that regime shifts in inflation’s responsiveness to economic conditions can occur, and that adaptive measures of inflation expectations, and even surveys of inflation, may not capture such a shift in real time. Chart II-18 shows that the 2014-2016 period was a good example of this, when adaptive expectations as well as household survey measures of long-term inflation expectations both lagged the actual decline in inflation that was caused by a collapse in the price of oil. Chart II-17The Trend In Inflation Continues To Respond To Economic Conditions The Trend In Inflation Continues To Respond To Economic Conditions The Trend In Inflation Continues To Respond To Economic Conditions Chart II-18Surveyed Inflation Expectations Can Lag, But This Time They Led Surveyed Inflation Expectations Can Lag, But This Time They Led Surveyed Inflation Expectations Can Lag, But This Time They Led But Chart II-18 also shows that long-term household survey measures of inflation led the rise in actual inflation (and thus our adaptive expectations measure) last year, underscoring that these measures are likely more reliable indicators today of whether a major regime shift is occurring. As noted above, long-term expectations have risen significantly relative to what prevailed prior to the pandemic, but this has merely raised expectations from extraordinarily depressed levels back to the average that prevailed prior to (and immediately after) the global financial crisis. Therefore, household expectations are not yet at dangerous levels. Chart II-19Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Third, one of the core observations in Rudd’s paper is that unit labor cost (ULC) growth leads the trend in inflation, which he argued was evidence against the idea that expectations of future inflation are a key determinant of actual inflation. Chart II-19 highlights that Rudd is correct that ULC growth modestly leads inflation (especially core inflation), but we disagree with his conclusion that it argues against the importance of expectations. As we noted in Section 2 of our January 2021 Bank Credit Analyst,5 one crucial aspect of the expectations-augmented, or “modern-day” Phillips Curve is that, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. Our view is that ULC growth is fundamentally linked to slack in the labor market, which is directly incorporated in output gap measures. As we noted above, investors currently have a good estimate of the magnitude of the output/employment gap, meaning that it is possible to track the inflationary consequences of prevailing aggregate demand. As a final point about ULC growth, Chart II-19 highlights that while the five-year CAGR of unit labor costs is currently running at its strongest pace since the global financial crisis, investors should note that it remains well below the levels that prevailed in the late-1960s when persistently above-potential output laid the groundwork for a massive inflationary overshoot. Conclusions And Investment Strategy Our review of the 1960s and 1970s highlights that stagflation is a phenomenon in which supply-side shocks raise prices of key inputs to production, which lowers output and raises unemployment. Energy price shocks in the 1970s occurred after a long period of policy-driven above-trend growth in the 1960s, meaning that both demand-pull and cost-push inflation contributed to stagflation in the 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been very expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. Chart II-20It Is Not Stagflation If The Unemployment Rate Continues To Fall It Is Not Stagflation If The Unemployment Rate Continues To Fall It Is Not Stagflation If The Unemployment Rate Continues To Fall However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part the result of strong goods demand and disruptions that are clearly linked to the pandemic (and thus will eventually dissipate), and long-term inflation expectations are behaving differently than short-term expectations, signaling that economic agents do not expect severe price pressures to persist beyond the pandemic. Policymakers also have more visibility about the magnitude of economic / labor market slack than they did during the stagflationary era and better tools to track inflation expectations. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not as a likely event. Using the Misery Index as real-time stagflation indicator, investors should note that the US economy is not likely experiencing true stagflation unless the unemployment rate rises. Chart II-20 highlights that there is no evidence yet of a contraction in goods-producing or service-producing jobs. Even if goods-producing employment slows meaningfully over the coming few months as a result of component shortages, the unemployment rate is still likely to fall if services spending normalizes, as it would imply that the gap in services-producing employment, which is currently 20% of the level of pre-pandemic goods-producing employment, will continue to close. Investors have been focused on the issue of stagflation because its occurrence would imply a sharply negative correlation between stock prices and bond yields. This is not our base case view, but we have highlighted that months with negative returns from both stocks and long-maturity bonds tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). As we discussed in Section 1 of our report, we do expect the Fed to raise interest rates next year. We do not see a rise in bond yields to levels implied by the Fed’s interest rates projections as being seriously threatening to economic activity, corporate earnings growth, or equity multiples. But the adjustment to higher long-maturity bond yields may unnerve equity investors for a time, implying temporary periods of a negative stock price / bond yield correlation. Table II-2 highlights that, since 1980, commodities, the US dollar, and the Swiss franc have typically earned positive returns during non-recessionary months in which stock and long-maturity bond returns are negative. While the dollar is not likely to perform well in a stagflationary scenario, Chart II-21 highlights that CHF-USD and industrial commodities performed quite well in the late-1970s. As such, a portfolio of these three assets might serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II- Chart II-21The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2 Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst “Work From Home “Stickiness” And The Outlook For Monetary Policy,” dated June 24, 2021, available at bca.bcaresearch.com 4 Rudd, Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?),” Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System. 5  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December 18, 2021, available at bca.bcaresearch.com

Dear Client, There will be no weekly report next week. Instead, we will host our quarterly webcast on Tuesday, October 26 for the US and EMEA regions and Wednesday, October 27 for the Asia Pacific region. We will resume our regular publishing schedule on Monday, November 1. In the meantime, we look forward to seeing many of you at our BCA Research Investment Conference this week. Best regards, Mathieu Savary   Highlights This year’s decline in EUR/USD has rendered this pair sufficiently inexpensive and oversold to account for the near-term risks we highlighted in March. Nonetheless, some risks remain—among them, the continued credit slowdown in China, diverging monetary policy trends, and the energy crisis hurting Europe. However, long-term fundamentals continue to support the euro’s 12- to 18-month outlook. Moreover, Chinese credit growth may soon stabilize and markets already largely factor in the policy divergence between the Fed and the ECB. As a result, we buy the euro today with a preliminary target at 1.25 and a stop loss at 1.1175. The Bank of England will lift rates this December, but the market already prices in a hawkish BoE. GBP/USD has upside, even if the euro should outpace the pound in the coming months. Look to upgrade UK small-cap stocks. Italian equities do not appear particularly appealing on a cyclical horizon, neither in absolute nor relative terms. Investors should favor Spanish stocks over Italian ones for the next 12-to-18 months. Feature EUR/USD recently flirted with 1.15. Did this move create a buying opportunity? Last March, we warned that the euro would correct to the 1.12 to 1.15 zone because short-term models flagged it as expensive, speculators carried a substantial net-long exposure, and Chinese credit growth was set to slow meaningfully. These forces have now mostly played out; thus, the euro’s near-term outlook is becoming more positive. Despite this more constructive view, EUR/USD still carries ample downside risks, especially if Chinese authorities remain reluctant to reflate their economy. Moreover, the energy crisis facing Europe clouds the euro. We are nonetheless buyers of EUR/USD, with a target at 1.25. Investors should set a wide stop in at 1.1175. Cheap And Oversold The internal dynamics of the euro indicate that the bulk of the sell-off is behind us. First, the euro is now cheap on a tactical basis. Back in March, our short-term fair value model for EUR/USD flagged at 7% overvaluation based on real rate differentials, on the slope of the German yield curve relative to that of the US, and on the copper-to-lumber prices ratio. Today, this same measure shows a 5% undervaluation. BCA’s Foreign Exchange Strategy Intermediate Term Timing Model (ITTM) flags an even clearer buy signal.  The ITTM framework combines interest rate parity models, with risk aversion and considerations for the currency’s trend. Currently, this model is at -8% or nearly minus one standard error. Historically, such a depressed reading points to generous returns in the subsequent 12 months (Chart 1). Second, the euro is oversold. BCA’s Intermediate Term Technical Indicator has hit 7, which is consistent with past rebounds in EUR/USD (Chart 2). While some of these rallies have been extremely short-lived, the technical indicator’s message is stronger when it is matched by a buy signal from the ITTM. Chart 1Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Chart 2EUR/USD is Oversold EUR/USD is Oversold EUR/USD is Oversold Chart 3Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Third, speculators do not carry a large net long position in the euro anymore. This variable suggests that the worst of the selling pressure is behind us, but it has yet to send a strong buy signal on its own (Chart 3). Bottom Line: The euro is sufficiently inexpensive that our Intermediate-term timing model flags a strong buy signal. Moreover, our technical indicators paint an oversold picture consistent with a reversal. Nonetheless, speculators may not be long EUR/USD anymore, but they are not aggressively selling it either. Thus, macro dynamics remain important to the future trend of this currency. Macro Fog Remains The macro environment is not yet conducive to a euro rally, especially when Chinese credit growth remains weak. However, considering the euro’s valuation and technical picture, small changes in the macro environment could be enough to catalyze a jump in EUR/USD. A key problem for the euro is that the dollar remains well bid. The yen and the dollar are the two momentum currencies within the G-10 (Chart 4). This property of the dollar is a large handicap for the euro, because it remains the most liquid vehicle to bet on the USD. Thus, as long as the dollar’s momentum is strong, the euro will find it difficult to rally. Relative economic growth is another headwind for EUR/USD. European activity is weakening versus that of the US. Since 2019, the relative manufacturing PMIs between the Euro Area and the US track EUR/USD, and they currently confirm the euro’s weakness (Chart 5). Moreover, European economic surprises are significantly weaker than US ones, which adds to the euro’s malaise (Chart 5, bottom panel). Chart 4The Dollar Is A Momentum Currency Time For The Euro To Shine? Time For The Euro To Shine? Chart 5Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD The near-term outlook does not signal a resolution of this issue until the first half of 2022. The declines in the expectation and current situation components of both the ZEW and Sentix surveys herald an additional deceleration in manufacturing activity (Chart 6). The Eurozone’s growth problems reflect China’s slowing credit flows. Europe economic activity is still extremely sensitive to the evolution of the global industrial cycle (Chart 7, top panel), much more so than the US GDP is. China’s business cycle is an essential determinant of the robustness of the global manufacturing sector. Consequently, when measures of China’s marginal propensity to consume decelerate, such as the gap between M1 and M2 growth, European PMIs and industrial production underperform those of the US (Chart 7, second and bottom panels). Chart 6A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends Chart 7China's Travails Hurt Europe China's Travails Hurt Europe China's Travails Hurt Europe     The fourth quarter of 2021 is likely to represent the tail end of the Chinese headwind on EUR/USD. The Chinese credit impulse remains weak, but signs of a floor are beginning to appear. For example, the decline in Chinese commercial banks excess reserve growth warned us of the coming decline in the credit impulse. Today, excess reserves have begun to stabilize, which points to an upcoming imporvement in credit flows (Chart 8). Additionally, the Evergrande problems continue to weigh on Europe in the near-term because of the deceleration in Chinese construction activity;  however, the crisis will also intensify the pressure on Beijing to revive credit growth in order to avoid a systemic collapse. Chart 8Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Monetary policy differentials also remain euro bearish. The US Federal Reserve will announce the start of its tapering program on November 3. The FOMC is set to hike rates by the end of 2022. Meanwhile, the ECB is unphased by the increase in European inflation, which remains mostly a reflection of energy prices and base effects. Thus, Europe will lag behind the US when it comes to monetary policy tightening. Nonetheless, investors already understand this dichotomy very well. The US OIS curve anticipates four hikes in 2023. Meanwhile, the EONIA curve shows a first 25-bps hike only by September 2023. Thus, the euro will suffer more from policy differentials if the Fed generates hawkish surprises relative to this pricing. The energy crisis shaking Europe is the last major headwind currently affecting the euro. Historically, EUR/USD and the ratio of European to US natural gas prices track each other (Chart 9). This relationship reflects relative growth dynamics. A stronger Eurozone economy relative to the US pushes up the value of the euro and European natural gas, which is a commodity with heavy industrial usage.  However, since this summer, the spike in European natural gas prices has coincided with a decline in the euro. This divergence highlights the negative effect on European activity of the current energy shock, which raises fears of stagflation. The cross-Atlantic bond market dynamics confirm the notion that the energy shock increases the perceived stagflation risk in the Eurozone. German yields have risen relative to US ones because of a pick-up in inflation expectations, not real rates (Chart 10). The lack of traction for relative real rates is appropriate because market participants believe that the ECB wants to ignore the spike in energy prices. An environment of rising relative inflation expectations but stable relative real rates is very negative for any currency, including the euro. However, European inflation expectations should decrease relative to those of the US once European natural gas prices normalize, which we expect to take place in the coming months (Chart 10, bottom panel). This process will be very positive for the euro. Chart 9The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro Chart 10Pricing In European Stagflation? Pricing In European Stagflation? Pricing In European Stagflation? Bottom Line: While euro pricing and technicals suggest EUR/USD will bottom soon, the economic environment is murkier. The dollar is a momentum currency, and its current strength feeds the euro’s weakness. China’s credit flows continue to decelerate, which hurts the euro; however, credit flows may stabilize in early 2022. The Fed is a tailwind for the dollar, but markets already price in this reality. Finally, the energy crisis hurts European growth and thus EUR/USD; nonetheless, the spike in natural gas prices will soon give way to a period of decline, which will lessen the pain for the euro. What To Do? When we balance the positives and negative for the euro, we are becoming more comfortable with buying EUR/USD outright, even if it is still a risky bet. To begin with, the big fundamental forces point to a firmer euro on an 18- to 24-month basis: BCA’s Foreign Exchange strategists see greater cyclical downside for the USD and believe the current rebound is a pronounced countertrend move within a multi-year dollar bear market. The euro will naturally benefit over the coming years from a weak greenback. EUR/USD is still inexpensive on long-term valuation metrics. Based on BCA’s purchasing power parity model, this pair trades 17% below its fair value. Moreover, the PPP estimate keeps rising in favor of the euro, a result of the Eurozone’s lower inflation compared to the US (Chart 11). The relative balance of payments favors the euro. The European economy generates a current account surplus of 3% of GDP compared to a current account deficit of 3.1% for the US. The US current account deficit is unlikely to narrow, even if the federal government’s budget hole declines because the private sector’s savings rate is falling even faster. Moreover, US real two-year rates remain well below those of its trading partners. Investors underweight Eurozone assets aggressively. For the past ten years, capital has consistently flowed out of the Euro Area relative to the US (Chart 12). European growth should converge toward the US next year, especially if Chinese credit activity stabilizes. Therefore, 2022 should witness a period of inflows into the Eurozone. Chart 11EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount Chart 12Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets We argued that the valuation and technical backdrop shows the Euro is becoming increasingly supportive and our timing model is clearly arguing against selling EUR/USD. However, the biggest technical risk is the momentum sensitivity of the dollar, which means that the euro’s weakness could last somewhat longer. Nevertheless, BCA’s Dollar Capitulation Index now warns of a pullback in the USD, especially as speculators are very long DXY futures (Chart 13). The biggest downside risk remains China’s credit trend. If it takes more time than we anticipate for Beijing to put an end to the credit impulse slowdown, the euro will experience greater downside pressure. Moreover, the longer it takes Beijing to reflate, the greater the chance of an uncontrolled selloff in the CNY, which would drag down the euro (Chart 14). Chart 13Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Chart 14China Remains The Euro's Main Risk China Remains The Euro's Main Risk China Remains The Euro's Main Risk Despite this level of near-term uncertainty, we recommend investors buy the euro, with a target at 1.25, and a stop loss at 1.1175. Bottom Line: Conditions are falling in place for the countertrend decline in the euro to end soon. As a result, the euro should converge back toward the upward path driven by fundamentals. The greatest near-term risk remains the path of Chinese credit trends. We recommend investors buy the euro with a preliminary target at EUR1.25 and a stop loss at 1.1175.   Country Focus: A Well Discounted BoE Hike The Bank of England will begin to increase interest rates at its December meeting. The BoE’s communication has been clear that it does not see a need to wait between the end of its tapering program in December and the beginning of its hiking campaign. Recent comments by senior MPC members, including new Chief Economist Huw Pill, also suggest a rate hike is looming. Chart 15The BoE's Inflation Problem The BoE's Inflation Problem The BoE's Inflation Problem We see little reason to doubt the willingness of the MPC to start lifting the Bank Rate. UK Core CPI stands at 3.1% or 110 basis points above the BoE’s inflation target. Moreover, both market-based and survey-based long-term inflation expectations are well above 3.5%, which increases the risk of a dangerous dis-anchoring of UK inflation (Chart 15). UK economic activity remains inflationary. Wages are strong, climbing 7.2% in August. This number probably exaggerates the underlying wage growth due to compositional effects, but job creation remains robust and the unemployment rate fell to 5.2%. The BoE was concerned that the end of the furlough scheme last month would cause a jump in unemployment, but their fears have dwindled, because job vacancies stand at a record high and capex intentions are solid (Chart 16). The housing market continues to be a tailwind to growth. House prices are up 10% annually, which lifts household net worth considerably (Chart 17). The pace of transactions in the real estate market will slow this spring because the stamp duty holiday will end; however, low mortgage rates and expectations of further housing gains may fuel greater appreciation. This creates long-term financial stability risks for the UK because household leverage will rise. This worries the BoE. Chart 16The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue Chart 17Rising Household Net Worth Rising Household Net Worth Rising Household Net Worth Market participants already expect a hawkish BoE. A rate hike is priced in for December and the SONIA curve embeds almost two more increases in 2022. The 4.3% underperformance of the UK government bond index over the global benchmark in seven weeks also underscores the rapid adjustment in investors’ perceptions of the UK policy path. BCA’s Global Fixed-Income strategists have underweighted UK government bonds for two months, and they maintain a negative view over the coming quarters.  Nonetheless, the risk of a short-lived countertrend rebound in UK bonds’ relative performance is significant. However, it would be a temporary position squaring, while hedge funds and CTAs take profits. BCA’s Foreign Exchange strategists expect GBP/USD to rebound. Cable is oversold and trades at a 12% discount to BCA’s PPP fair-value estimate. GBP/USD is also hurt by fears that the BoE hikes will damage the UK economy. From a contrarian perspective, this creates a positive entry point to buy cable, especially because the pound should benefit from the anticipated dollar weakness and the euro’s upcoming rally. However, BCA’s FX strategists also foresee some decline in the pound versus the euro, because GBP is a low beta play on EUR/USD. Hence, the trade-weighted pound could remain flat to slightly down in the coming months. We stay neutral on UK small-cap stocks relative to large-cap equities, but we are putting them on an upgrade alert. Small-cap stocks benefit from the strength in the domestic economy; however, they are also extremely expensive compared to large-cap ones (Chart 18). The arbiter of performance will be profits. The forward EPS of small-caps have lagged behind those of large-caps by 9% since the COVID recession, after underperforming since 2016 (Chart 19). Small-caps’ relative profits are currently trying to stabilize, but the durability of this trend will be tested if the trade-weighted pound remains flat in the coming months. Thus, the EPS of small-cap shares must regain more ground before moving more aggressively in this market. Chart 18UK Small Cap Are Pricey UK Small Cap Are Pricey UK Small Cap Are Pricey Chart 19Follow The Profits Follow The Profits Follow The Profits Bottom Line: On the back of a strong UK economy and significant inflationary forces, the BoE will start elevating interest rates this December. The market already prices in this outcome. Nonetheless, UK bonds should continue to underperform the global benchmark, and cable has upside, even if the near-term outlook favors the EUR over the GBP. We are putting UK small-cap stocks on a buy alert. They are expensive, but a turnaround in profits would solve this problem. Market Focus: A Quick Take On Italian Equities The Italian equity market remains Europe’s problem child. The Italian MSCI index has underperformed the rest of the Euro Area by 40% since 2010. This underperformance holds even after adjusting for sectoral differences, although it becomes less dramatic (Chart 20, top panel). Despite this underperformance, Italian equities have managed to outperform their Spanish counterparts by 27% since 2010, but this outperformance dissipates once sectoral difference are accounted for (Chart 20, bottom panel). The RoE of Italian non-financial listed equities is equivalent to the rest of the Eurozone, but it only reflects elevated financial leverage, as is the case in Spain (Chart 21). Italy’s RoA is poor, because Italy’s excess capital stocks hurts its return on capital. As a result, Italian equities continue to face a structural handicap. Chart 20A Problem Child A Problem Child A Problem Child Chart 21Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor The good run in Italian equities in absolute terms faces headwinds. Italian stocks are very sensitive to the global business cycle; however, they often respond with a delay and in an exaggerated fashion to decelerations in the global PMI (Chart 22, top panel). Moreover, since 2010, widening European high-yield corporate bond spreads have preceded falling Italian stock prices. Thus, the recent slide in the global PMI and the widening in European high-yield OAS create a period of vulnerability for Italian equities. Finally, Italian share prices have overshot the path implied by US yields (Chart 22, bottom panel). Nonetheless, Italian stocks may be sniffing out further increases in global yields. The cleanest way to play these vulnerabilities in the Italian is via a short bet against Spain. A steeper global yield curve will help both markets due to their heavy exposure to financials. However, we still favor Spanish financials, which benefit from higher RoEs than their Italian counterparts (Chart 23) and lower NPLs. As a result, the forward EPS of Spanish financials should begin to outperform those of Italian financials. Chart 22Some Risks To Italian Stocks Some Risks To Italian Stocks Some Risks To Italian Stocks Chart 23Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Cyclical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Structural Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Closed Trades Time For The Euro To Shine? Time For The Euro To Shine? Currency Performance Fixed Income Performance Equity Performance

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Chart 2Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 4… But The Nominal USD Value Rises Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 8 Uncertainty Weighs On Gold Uncertainty Weighs On Gold   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

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