Utilities

Highlights The ECB is not repressing interest rates and penalizing savers. The Eurozone shows none of the symptoms associated with financial repression. Global excess savings are keeping US rates depressed. If US rates are low, then European rates must be lower because of structural problems in the region’s economy, independent of the ECB’s preferences. Structurally, there is still no case for European yields to rise meaningfully compared to the rest of the world. Despite positive forces over the next year or two, European financials will remain long-term underperformers. European utilities will outperform US ones. The euro is transforming into a safe haven like the yen and the Swiss franc. Feature By maintaining negative short rates, the European Central Bank is conducting severe financial repression, which distorts rates of return and penalizes savers. This is a common refrain among many insurers and pension plan managers investing in Europe and among a large number of the region’s politicians. Chart 1The ECB's Financial Repression? The ECB's Financial Repression? The ECB's Financial Repression? At first glance, this criticism is apt. For the past five years, negative policy rates have forced safe-haven Bund yields to trade well below the Euro Area’s nominal GDP growth (Chart 1). Moreover, the real ECB deposit rate remains well below the Holston, Laubach-Williams estimate of R-star (the real neutral rate of interest). If we go beyond these superficial observations, it is far from clear that the ECB is conducting financial repression or distorting market rates any more than other major global central banks. Is It Financial Repression? The ECB is not conducting financial repression; rather, it is responding to powerful economic forces in Europe and beyond that are depressing interest rates. The definition of financial repression is crucial to this assessment. Financial repression involves monetary authorities actively suppressing interest rates to the advantage of the borrowers and users of capital at the expense of the savers, whose risk-free investments then provide subpar rates of returns. Following this definition, financial repression shows these clear symptoms: A low savings rate. Suppressed interest rates do not adequately compensate savers to forgo consumption. Thus, they are less likely to put money aside. A significant build-up of debt. Real interest rates are below fair market value, which subsidizes borrowing. A significant expansion of the money supply. Money supply expands rapidly in response to strong credit demand in the economy. Plentiful capital expenditures. Savers must take on more financial risk to make appropriate returns on their assets, which compresses risk premia. Depressed internal rates of return boost the net present value of investment projects and thus cause investments to account for a large share of output. A current account deficit. A nation’s current account balance equals its savings minus its investments. By depressing savings and stimulating investments, financial repression results in a current account deficit or a sharply deteriorating current account balance. Above-trend GDP growth. By depressing savings and boosting investments, financial repression lifts cyclical spending and forces the GDP to rise above its potential. The problem for commentators who argue that the ECB is conducting financial repression is that the Euro Area meets none of these criteria. First, Eurozone money and credit growth has run well below that of the US ever since the euro crisis, despite ECB policy rates that are constantly lower than the Fed Funds rate. Moreover, since the ECB cut rates to zero, the pace of money and credit creation has decelerated significantly compared to their pre-crisis trends (Chart 2). Second, the Euro Area’s real GDP per capita, nominal GDP per capita, and the GDP deflator have also fallen 4.6%, 5.2% and 5%, respectively, behind those of the US, since the ECB has cut interest rates to zero (Chart 3). Moreover, the growth of these variables has also decelerated significantly over this period, which is consistent with depressed credit demand. Additionally, despite the inferior performance of European activity metrics compared to those of the US since the introduction of the common currency, European government bonds have performed exactly in line with those of the US (Chart 3, bottom panel) and have therefore outperformed in real terms. This is inconsistent with financial repression by the ECB. Chart 2Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Chart 3... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends Finally, the Euro Area runs a current account surplus of 2.3% of GDP, which has grown by 4.1% of GDP since late 2008. This is the clearest sign that Eurozone savings have become excessive relative to investment, despite the surge in government deficits in the wake of the COVID-19 pandemic. Excess savings are not typically associated with central banks artificially distorting interest rates. Bottom Line: The economic developments in the Euro Area do not correspond to what would be anticipated if the ECB were repressing interest rates. The growth rate of money and credit has structurally slowed both in absolute terms and compared to that of the US. The same deceleration is evident in both real and nominal output per person, as well as in price levels. Finally, the Eurozone’s current account surplus has widened, which highlights that savings have grown in excess of investments. The Eurozone Needs Lower Interest Rates Than The US The ECB must set appropriately low interest rates, if US yields are low across the curve. In a way, the case that the Federal Reserve is conducting financial repression is stronger than the case against the ECB. Over the past twelve years, nominal and real output per capita have grown more robustly in the US, while money as well as credit expansion and inflation have also been stronger. The US runs a persistent current account deficit of 3.1% of GDP, which also indicates that it is not awash in excess domestic savings. Chart 4Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates We could even argue that the case for the Fed repressing interest rates is growing stronger. The federal budget deficit has expanded to 19% of GDP, even as the unemployment rate tumbles (Chart 4). Moreover, US quarterly GDP growth has averaged 8.5% since the fourth quarter of 2020 and, according to Bloomberg consensus estimates, is anticipated to average 6.3% for the remainder of the year. US inflation is also strong. Annual core CPI Inflation hit 3% in April; monthly core inflation was 0.92%, or an annualized rate of 11.6%, the strongest reading in almost 40 years. Yet, even in the US, the argument that the Fed is repressing interest rates is ultimately weak, despite the aforementioned economic strength. The Fed is accommodating global market pressures that are greater than those of the US economy. In other words, even if the Fed did not set short rates, US interest rates would be low across the curve because of global excess savings. Chart 5Too Much Savings, Everywhere Too Much Savings, Everywhere Too Much Savings, Everywhere Excess savings around the world constitute an exceptionally strong gravitational force that anchor global rates at low levels. As Chart 5 shows, since the early 1990s, global private savings have outpaced investments by a cumulative 163% of GDP. Accumulated government deficit, which has accounted for 99% of global GDP, has been far too small to absorb fully this surplus of savings. The resulting imbalance places downward pressure on global inflation (a consequence of demand falling short of supply) and real interest rates, which means it depresses nominal interest rates across the curve. US interest rates also feel the yield-compressing effect of these excess global savings, even if the US economy does not generate excess savings itself (it runs a current account deficit). The major DM central banks are removing a greater proportion of the float of safe-haven from their jurisdictions than the Fed (Chart 6). The resulting scarcity of safe-haven securities means that US fixed-income products remain the natural outlet for global investors seeking safety and liquidity. Thus, despite the US lack of excess savings, Treasury yields have traded below nominal GDP growth 55% of the time over the past 30 years, no matter how strong US activity is or how wide federal deficits become. If the Fed has little choice but to accept low US interest rates, then the Eurozone must accept even lower interest rates because of its large excess savings. As Chart 7 illustrates, the 2-year and 10-year interest rate spreads (both in nominal and real terms) between the Eurozone and the US track the gap between the US current account deficit and the Europe’s current account surplus. Chart 6Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Chart 7Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve The Eurozone lower rate of return on capital is another force depressing rates relative to the US (Chart 8). This lower return on capital reflects the following structural problems with the European economies: Excess capital stock. The Eurozone peripheral nations have abnormally large capital stocks in relation to their GDPs (Chart 9). As we previously argued, this feature means that Europe suffers from large amounts of misallocated capital, which hurt the return on capital. Chart 8Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Chart 9Too Much Capital! Too Much Capital! Too Much Capital! Ageing capital stock. Not only is the Eurozone capital stock too large relative to the size of its economy, it is also older than that of the US (Chart 10). An ageing capital stock, especially in a world where ICT spending is one of the key sources of innovation and growth, further hurts the Euro Area’s return on capital. Lower incremental output-to-capital ratio (Chart 11). The Euro Area generates significantly less output per unit of investment than the US. This confirms the notion that capital is misallocated and that it is used less productively than in the US. Chart 10Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Chart 11Poor Capital Utilization Poor Capital Utilization Poor Capital Utilization Chart 12Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem The final force limiting European interest rates compared to the US is the Euro Area’s inferior potential growth rate. The Eurozone’s population is ageing, and it will start to contract in 2030. Moreover, multifactor productivity growth is weaker than in the US (Chart 12). A lower potential GDP growth accentuates the discount in the Euro Area neutral rate of interest compared to the US. Bottom Line: Despite the relative economic vigor of the US, global excess savings lower US rates across the curve. The ECB has no choice but to accept even lower European rates, because the European economy suffers from greater excess savings than the US: its return on capital is inferior, and its neutral rate of interest is hampered by its lower potential GDP growth. Investment Conclusions For European rates to avoid the fate of Japan and to circumvent suffering many more decades wedged near zero, some important changes must take place. First, at the global level, excess savings must recede. This will allow global interest rates to increase, especially those of the US. Even if Eurozone rates continue to trade at a discount to the US, safe-haven yields in Europe would nonetheless climb in absolute terms. The fall in the global ratio of workers relative to dependent people, most notably in China where the 2020 population census has just highlighted the trend, is one factor pointing toward a potential gradual decline in global savings. For the moment, absorbing excess savings means that global fiscal policy must remain accommodative. Although fiscal authorities around the world continue to display greater profligacy than they did in the wake of the Great Financial Crisis, there is no guarantee that they will not revert to their old ways. In fact, BCA’s Global Investment Strategy service recently showed that the US fiscal policy is set to become more of a constraint on growth next year than it has been in 2020 and 2021 (Chart 13).  One factor to monitor is the international shift in voters’ preferences toward left-wing economic policies, which often results in more generous fiscal spending. If this trend persists, then global fiscal deficits will close more slowly than the private sector savings will decline. This process will both be inflationary over the long run and impose upward pressure on real interest rates worldwide. But the fiscal excesses of the current moment may force opposition parties to restrain spending whenever they come into power. Chart 13Will Global Fiscal Policy Morph Into a Headwind? The ECB Is Not In Charge The ECB Is Not In Charge Second, to narrow the spread between the Eurozone and US interest rates, the Euro Area must tackle its low rate of return on capital. Practically, this means that much of the excess capital stock weighing on European rates of returns must be written down. Doing so will require more cross border mergers and acquisitions within sectors in the Eurozone. However, the loss-recognition process on nonviable capital will be deflationary. Thus, to facilitate these asset write-downs, the region’s fiscal policy and monetary policy must first remain extremely accommodative. It is far from certain that European authorities will resist reverting to their old ways. A structural underweight on European financial equities remains appropriate. Even if the Eurozone enacts the reforms necessary to invite the peripheral asset write-downs required to boost rates of return in the long-run, in the interim, these reforms will be deflationary. Consequently, no matter what, Eurozone yields will remain well below the US for years to come. Moreover, European credit demand is unlikely to outperform the rest of the world for the coming few years. In this context, the RoE of European banks will remain low. Therefore, our current recommendation to overweight this sector is only valid as a near-term play on the global economic recovery and is not a strategic recommendation. By contrast, European utilities will structurally outperform their US counterparts. European utilities offer higher RoE than US ones and have healthier leverage (Chart 14). Moreover, European utilities trade at discounts to US firms on a price-to-book, price-to-cash flow, price-to-sales and dividend yield basis (Chart 15). Additionally, as yield plays, structurally lower European yields relative to those of the US will advantage European utilities on a long-term basis. Chart 14European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... Chart 15... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones Finally, the euro will increasingly trade as a safe-haven currency like the yen and the Swiss franc. First, after a decade of trial by fire, EU integration and solidarity have gained rather than lost momentum and the EU break-up risk has proved to be limited to Brexit. Second, although the Eurozone economy is pro-cyclical, so are the Swiss and Japanese economies. Instead, the Euro Area’s structurally elevated savings rate and current account balance are transforming this economy into a net creditor, with a positive net international investment position equal to -0.1% of GDP. Moreover, the bloc’s low inflation will continue to put upward pressure on the euro’s long-term fair value. If we add the Euro Area’s low interest rates to the mix, then the euro is likely to behave increasingly as a funding currency. Thus, while the euro will benefit from the USD’s weakness forecasted by our Foreign Exchange Strategists, it will underperformed more pro-cyclical currencies such as the SEK, the NOK, or the GBP, which do not suffer from the same ills as the Eurozone.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Highlights US natural gas prices will remain well supported over the April-October injection season, as the global economic expansion gains traction, particularly in Europe, which also is refilling depleted storage levels. China's natgas demand is expected to rise more than 8% yoy, and EM Asia consumption also will be robust, which will revive US liquified natural gas (LNG) exports. Exports of US light-sweet crude into the North Sea Brent pricing pool – currently accounting for close to half the physical supply underpinning the global oil-price benchmark – also will increase over the course of the year, particularly in the summer, when maintenance will markedly reduce the physical supply of crudes making up the Brent index. At the margin, coal demand will increase in the US, as industrial natgas demand and LNG exports incentivize electric generators to favor coal. Higher-than-expected summer temperatures in the US also would boost coal demand.  This will be tempered somewhat in Europe, where carbon-emissions rights traded through €50/MT for the first time this week on the EU's Emission Trading System (ETA). We expect US LNG and oil exports to revive this year (Chart of the Week) and remain long natgas in 1Q22. Feature The importance of US LNG and crude oil exports out of the US Gulf to the global economy is only now becoming apparent. As demand for these fossil fuels grows and the supply side continues to confront a highly uncertain risk-reward tradeoff, their importance will only grow. In natgas markets, US LNG cargoes out of the US Gulf balanced demand coming from Asia and Europe this past winter, which was sharply colder than expected and stretched supply chains globally. As a widening economic recovery from the COVID-19 pandemic spurs industrial, residential and commercial demand, and inventories in Europe and Asia are re-built in preparation for next winter, US LNG exports will be called upon to meet increasing demand, particularly since they are priced attractively vs regional importing benchmarks, with differentials vs the US presently $4+/MMBtu vs Europe and $5+/MMBtu vs Asia (Chart 2).1 Chart of the WeekUS LNG, Oil Export Growth Will Rebound US LNG, Oil Export Growth Will Rebound US LNG, Oil Export Growth Will Rebound Chart 2Lower US Natgas Prices Encourage LNG Exports Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily In oil markets, an ongoing kerfuffle in the pricing of Brent Blend brought about by falling North Sea crude oil production makes American light-sweet crude oil exports from the Gulf (i.e., WTI produced mostly in the Permian Basin) account for almost half of the physical supplies in this critical benchmark-pricing market.2 US LNG Exports Will Increase US natural gas prices will remain well supported as the global economic expansion gains traction, and the US and Europe open the April-October injection season well bid (Chart 3). US inventories are expected to end the Apr-Oct injection season at just over 3.7 TCF according to the EIA, very close to where they ended the 2020 injection season. Chart 3US, Europe Rebuild Storage Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily Higher US LNG exports, industrial, commercial and residential demand will be offset by lower consumption from electric generators this year, netting to a slight decline in overall demand. The EIA expects generators to take advantage of lower generating costs to be had burning coal to produce electricity, a view we share given the current differentials in the forward curves for each fuel (Chart 4).3 On the supply side, the EIA's expecting output to remain unchanged from last year at just under 91.5 BCF/d in 2021. Higher LNG exports, even as generator demand is falling, pushes prices higher this year – averaging $3.04/MMBtu this year – which leads to a slight increase in output in 2022. For our part, we continue to expect higher prices during the November-March heating season than currently are clearing the market and remain long 1Q22 $3.50/MMBtu calls vs. short $3.75/MMbtu calls. As of Tuesday night, when we mark to market, this position was up 20.8% since inception on 8 April 2021. Chart 4Lower Prices Will Favour Increased Coal Demand Lower Prices Will Favour Increased Coal Demand Lower Prices Will Favour Increased Coal Demand Natgas demand could surprise on the upside during the injection season if air-conditioning demand comes in stronger than expected and production remains essentially unchanged this year. This could reduce LNG exports and slow the rate of inventory refill in the US, which could further advantage coal as a burner fuel for generators in the US. The US National Weather Service's Climate Prediction Center expects above-average temperatures for most of the US population centers this summer (Chart 5). This could become a semi-permanent feature of the market if current temperature trends persist (Chart 6). Based on analyses’ run by the NOAA's National Centers for Environmental Information, 2021 "is very likely to rank among the ten warmest years on record," with lower (6%) odds of ranking in the top five hottest years on record.4 Chart 5Odds Of Hotter Summer Rising Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily Chart 6Higher Global Temperatures Could Become A Recurring Phenomenon Importance Of US Gas, Oil Exports Increases Daily Importance Of US Gas, Oil Exports Increases Daily The Crude Kerfuffle As the Chart of the Week shows, US exports of light-sweet crude oil peaked at ~ 3.7mm b/d in February 2020, just before the COVID-19 pandemic hit the world full force. Exports out of the US Gulf – i.e., WTI priced against the Midland, TX, gathering hub – accounted for ~ 95% of these volumes. With exports currently running ~ 2.5mm b/d, more than 1mm b/d of readily available export capacity remains in place. Additional volumes will be developed as dredging of the Corpus Christi, TX, progresses. While the surge in US crude oil production has subsided in the wake of the pandemic, it most likely will revive as the markets return to normal operating procedure, additional dredging operations are completed, and storage facilities are built out.5 Existing and additional export capacity of the US's light-sweet crude could not arrive at a more opportune time for the Brent market, which remains in a state of uncertainty as to whether markets will have to adjust to CIF contracts or a work-around to the existing FOB pricing regime, which can be augmented to accommodate increasing WTI volumes.6 This will have to be sorted, as this is the future of the market's most important pricing index (Chart 7). The buildout in crude-oil exporting capacity – and natgas LNG exporting capacity, for that matter – ideally accommodates shale-oil- and -gas assets, which can be ramped up quickly to meet demand, and ramped down quickly as demand falters. The quick payback – 2 to 3 years – on these investments allow the producers to expand and contract output without the massive risks longer-lived conventional assets impose. As OPEC 2.0's spare capacity is returned to the market, this will be a welcome feature of a market that most likely will require oil and gas supplies for decades, despite the uncertainty attending oil-and-gas capex during the transition to a low-carbon energy future. Chart 7Permian Replaces North Sea Losses Permian Replaces North Sea Losses Permian Replaces North Sea Losses Bottom Line: As the future of hydrocarbons evolves, the LNG and crude oil exported from the US Gulf will occupy an increasingly important role in these markets. Oil and gas producers are making capex decisions under increasingly uncertain conditions, which favor exactly the type of resources that have propelled the US to the position of the world's largest producer of these fuels – i.e., shale-oil and -gas. Production from these resources can be ramped up and down quickly as prices dictate, and have quick paybacks (2-3 years), which means capital is not tied up for decades as a return is earned.7   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 begins returning 2mm b/d to the market this month, expecting to be done by July. Half of these volumes are accounted for by Saudi Arabia, which voluntarily cut output by 1mm b/d earlier in the year to help balance the market. In line with our maintained hypothesis that OPEC 2.0 prefers prices inside the $60-$70/bbl price band, we expect the return of curtailed production to be front-loaded so as to bring prices down from current levels approaching $70/bbl for Brent (Chart 8). If, as we expect, demand recovers sooner than expected as Europe leans into its vaccination program, additional barrels will be returned to the market to get prices closer to a $60-$65/bbl range. Base Metals: Bullish The International Copper Study Group (ICSG) forecast copper mine production will increase by ~ 3.5% in 2021 and 3.7% in 2022, after adjusting for historical disruption factors. This forecasted increase – after three years of flat mined production growth – is due to a ramp-up of recently commissioned and new copper mines becoming operational in 2021. An improvement in the pandemic situation by 2022 will also boost mined copper production, according to the ICSG. 2020 production remained flat as recoveries in production in some countries due to constrained output in 2019 balanced the negative impacts of the pandemic in others. In Chile, the largest copper producer, state-owned Codelco and Collahuasi reported strong results in March. However, this was countered by a continued downturn at BHP’s Escondida. The world’s largest copper mine saw a drop in production for the eighth consecutive month. This mixed output resulted in a decline in total production of 1.2% year-on-year in March. Precious Metals: Bullish COMEX palladium touched a record high during intraday trading on Tuesday, reaching $3,019/oz due to continued tight market conditions (Chart 9). On the supply side, Nornickel is recovering from flooded mines, which occurred in February. By mid-April, one of the two affected mines was operating at 60% capacity; however, the company's other mine is only expected to come back online by early June. On the demand side, strength in US vehicle sales and a global economic recovery from the pandemic buoyed the metal used in catalytic converters. Palladium prices closed at $2,981.60/oz on Tuesday. Ags/Softs: Neutral Corn again traded above $7/bu earlier in the week on the back of drought-like dry weather conditions in Brazil's principal growing regions and surging US exports, according to Farm Futures. Chart 8 Brent Prices Going Up Brent Prices Going Up Chart 9 Palladium Prices Going Up Palladium Prices Going Up   Footnotes 1     Stronger demand from China – where consumption is expected to rise more than 8% yoy – and EM Asia will continue to support LNG demand through the year.  S&P Global Platts Analytics expects Chinese natural gas demand to reach 12,713 Bcf in 2021, up 8.4% from the previous year.  Chinese national oil company Sinopec is slightly more conservative in its outlook, expecting gas demand of ~ 12,006-12,184 Bcf in 2021, up 6-8% from 2020.  China’s average annual increase in natural gas demand is expected to exceed 716 Bcf in the 14th FYP and reach 15,185 Bcf in 2025. 2     Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies for a discussion. 3    In Chart 3, we plot a rough measure of coal- vs natgas-fired generation economics for these fuels based on their average operating heat rates published by the EIA. We would note that a carbon tax would erase much of the benefit accruing to coal at this point in time. 4    Please see NOAA's Global Climate Report - March 2021. 5    Please see Low Rider - Corpus Christi's Ship Channel Dredging Will Streamline Crude Oil Exports published by RBN Energy 3 May 2021. 6    The OIES analysis cited above concludes, "… the volumes of the FOB deliverable crudes are diminishing and some change, bolstering the contract is certainly needed. The most likely compromise is to retain the existing FOB Brent with an inclusion of CIF WTI Midland assessment, netted back to an FOB equivalent North Sea value."  We agree with this assessment.  Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies, p. 8. 7     Please see Is shale activity actually profitable? Size matters, says Rystad published 7 February 2019.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE Chart 9 Covid Uncertainty Could Push Up Gold Demand Covid Uncertainty Could Push Up Gold Demand   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Shades Of 2003/4? Shades Of 2003/4? Chart 2 Shades Of 2003/4? Shades Of 2003/4? As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Appendix Appendix Chart A2 Appendix Appendix Chart A3 Appendix Appendix Chart A4 Appendix Appendix Chart A5 Appendix Appendix Chart A6 Appendix Appendix Chart A7 Appendix Appendix Chart A8 Appendix Appendix Chart A9 Appendix Appendix  

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact Bearish Trend Intact Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration No Panic From Powell No Panic From Powell This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators Cyclical & Valuation Indicators Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Financial Conditions Are Easy Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity Treasury Market Liquidity Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive Reserve Supply Is Massive Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios No Panic From Powell No Panic From Powell If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries.   In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Fed Created ON RRP In 2013... Fed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward.   Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date No Panic From Powell No Panic From Powell This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry No Panic From Powell No Panic From Powell Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear client, Next week instead of our regular Strategy Report we will be sending you a Special Report from BCA’s Equity Analyzer service on Inflation and Factor investing penned by my colleague Lucas Laskey, Senior Quantitative Analyst. Finally, on February 22 we will be hosting our quarterly webcast one at 10am EST for North American and EMEA clients and one at 8pm EST for Asia Pacific, Australian and New Zealand clients “From Alpha To Omega With Anastasios”. Mathieu Savary, who heads our Daily Insights service, will be our special guest in the morning webcast. On March 1 we will resume our regular publication schedule. Kind Regards, Anastasios Highlights Portfolio Strategy China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Continue to overweight the S&P software index.  Recent Changes Last Tuesday we closed out our VIX futures hedge for a gain of 19% since the December 7, 2020 inception. Last Wednesday we re-initiated our long “Back-To-Work”/short “COVID-19 Winners” pair trade. Feature Equity volatility settled down last week following a ferocious ten-day SPX oscillation that sent the VIX soaring to roughly 38 near the peak at the end of January, courtesy of the GME/Wallstreetbets (WSB) saga before collapsing back down near 21 last week. Chart 1 shows that this was likely an equity-only event: both risk off currencies – the yen and the franc – actually fell versus the USD, junk bond spreads barely budged and the vol curve violently inverted, a move that more often than not signals that complacency has morphed into panic. Importantly, when the Fed embarks on active QE the SPX drawdown maxes out at 10% based on empirical evidence, including the recent September/October 10% drawdown. Using the ES futures low hit two Sundays ago, the S&P 500 experienced a 5.3% peak-to-trough pullback well within the range of previous Fed active QE iterations. As a reminder, the 2010 and 2011, 17% and 20% respective drawdowns took root after the Fed had concluded QE1 and QE2 operations. The implication is that for a more significant drawdown to materialize, likely the Fed has to end the current QE operation and reinject some volatility in the bond markets (bottom panel, Chart 1).  Isolating the true signal from all this noise, convinced us to book handsome gains to the tune of 19% in our VIX June futures hedge (conservatively assuming that no leverage was used), reinitiate the long “Back-To-Work”/short “COVID-19 Winners” pair trade and put the small cap size bias on our upgrade watch list. As volatility has slowly died down, investors can start to refocus on profit fundamentals. Similar to the steep fall in EPS that the SPX 35% drawdown predicted in March of 2020, in recent research we showed that were we to hold the SPX at current levels, its 12-month rate-of-change would surpass the 61% mark next month and forecast that profit growth would rise by a similar amount. Indeed, sell side analysts’ bottom up earnings estimates corroborate this analysis as quarterly EPS will peter out roughly at a 48% year-over-year (YOY) growth rate next quarter and vault to all-time highs in quarterly level terms in Q3 following a three-year hiatus (Chart 2). Chart 1Equity-only Event Equity-only Event Equity-only Event Chart 2Joined At The Hip Joined At The Hip Joined At The Hip Importantly, the tech sector no longer commands an earnings weight similar to its market cap weight likely because it’s run ahead of itself and also because the rest of the sectors are playing catch up this year as the US economy is slated to reopen on the back of the herculean inoculation efforts (profit weight and mkt cap weight columns, Table 1). Table 1Sector EPS And Market Cap Weights Re-grossing? Re-grossing? This is most evident on the sector contribution to this year's SPX earnings growth. Historically, the tech sector commanded the lion’s share of profit explanation for the SPX, but not in 2021. In fact, the S&P IT sector is ranked 4th in terms of contribution to overall SPX profits, behind industrials, financials and consumer discretionary (Chart 3).   Delving deeper into 12-month forward earnings growth figures is instructive. Table 2 shows our universe of coverage ranked first by GICS1 sector growth rates and then re-ranked per sub-group. As an aside the energy sector’s EPS is slated to contract in calendar 2020 and thus any YOY growth rate figures are rendered useless for the broad sector and the energy sub-industries. Chart 3Sector Contribution To 2021 SPX EPS Growth Re-grossing? Re-grossing? Table 2Identifying S&P 500 Sector EPS Growth Leaders And Laggards Re-grossing? Re-grossing? Our portfolio positioning is well aligned with the sector ranking of EPS growth for the coming year. Put differently, given the havoc that COVID-19 wreaked to the US industrial and service bases it is normal that deep cyclical sectors along with financials and the decimated services-heavy parts of the consumer discretionary sector to occupy the top ranks. In contrast, defensives sectors that were largely COVID-19 beneficiaries (especially health care and consumer staples) are near the bottom of the pit. The sole misalignment is the bombed out real estate sector that we remain overweight (Table 2). Netting it all out, our sense is that the market has successfully navigated a tumultuous two-week period and we reiterate our long-held sanguine 9-12 month cyclical view on the prospects of the S&P 500. This week, we update a defensive tech sub-group and put a tight stop in the cyclicals/defensives portfolio bent in order to protect profits. Risks To The Cyclicals Over Defensives Portfolio Bent Last December we highlighted that China’s four year cycle will peter out in the back half of 2021 and could cause some equity market consternation, with stocks likely sniffing out any trouble likely by the end of Q1/2021. It appears that investors have been sleeping at the wheel and largely distracted by the GME/WSB saga. Not only did they neglect the robust SPX profit season, but they also ignored that something is amiss in China as we first showed last week (please refer to Chart 12 here). Importantly, what worries us most is the transition from China being the primary locomotive of global growth to the US taking the reins in coming quarters. Clearly such a handoff is tumultuous, especially given the recent added risk of a reflex rebound in the greenback that we first warned about on January 12 when we set the cyclicals/defensives ratio on downgrade alert. Subsequently, we upgraded the S&P utilities sector to neutral locking in gains of 15% for the portfolio, and today we decide to institute a 2.5% rolling stop in the cyclicals/defensives portfolio bent, in order to participate on further upside but also protect 16% gains for the portfolio since the July 27, 2020 inception in case of a market relapse. Practically, when the rolling stop gets triggered we will move the cyclicals/defensives bent down to neutral via executing the downgrade alert we have in the S&P materials sector. In more detail, China’s slamming on the brakes is the key risk to cyclicals/defensives. Not only are the Chinese authorities trying to engineer a slowdown with the recent reverse repo operations, but also BCA’s China Monetary Indicator, the selloff in the Chinese sovereign bond market and the cresting in the PBOC’s balance sheet are all corroborating the economic deceleration signal (Chart 4). Chinese total social financing has peaked, the 6-month credit impulse is plunging, and the nosedive in Goldman Sachs’ Chinese current activity indicator (CAI) are all firing warning shots that the economy is slated to slowdown (Chart 5).  Chart 4Everywhere… Everywhere… Everywhere… Chart 5…One Looks… …One Looks… …One Looks… Already both the Chinese manufacturing and services PMIs have hooked down with the manufacturing new orders-to-inventories (NOI) in free fall and export orders in outright contraction. Tack on the reversal in the Citi economic surprise index (ESI) for China and the outlook dims further for US cyclicals/defensives (Chart 6). No wonder Chinese demand for loans has turned the corner, infrastructure spending has topped out and railway freight volumes have ticked down as a direct response to the tightening in Chinese monetary conditions (Chart 7). Chart 6…China… …China… …China… Chart 7…Is Slowing… …Is Slowing… …Is Slowing… Chinese imports flirting with the zero line best capture all this softening in Chinese data and also warns that the US cyclicals/defensives ratio is nearing a zenith (Chart 8). Beyond the dual risk of a counter trend rally in the USD and China’s undeniable deceleration, returning to US shores reveals another source of potential trouble for cyclicals/defensives. Chart 8…Down …Down …Down The US Citi ESI has come back down to earth, and the ISM manufacturing PMI cooled off last month with the NOI ratio flashing red (Chart 9). Importantly, Goldman Sachs’ US CAI is sinking like a stone corroborating that, at the margin, US economic data is softening (Chart 10). Moreover, US capex is in the doldrums courtesy of the collapse in EPS last year that dealt a blow to CEO confidence. Worrisomely, the rollover in the latest capex intentions from regional Fed surveys along with the downbeat NFIB survey’s capital outlays in 6-months component underscore that CEOs remain reluctant to invest (Chart 9). Chart 9Even US Trouble… Even US Trouble… Even US Trouble… Finally, relative valuations have surged to all-time highs leaving no cushion in case of a mishap, while relative technicals are in extreme overbought territory near a level that has marked the commencement of prior relative share price drawdowns (Chart 11). Chart 10…Is Brewing …Is Brewing …Is Brewing Netting it all out, China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Bottom Line: Prepare to move the cyclicals/defensives portfolio bent back down to neutral from currently overweight. Today we recommend investors establish a 2.5% rolling stop to the cyclicals/defensives relative share price ratio as a risk management tool in order to protect profits. Chart 11Overstretched And Pricey Overstretched And Pricey Overstretched And Pricey Software On The Ascend While we remain on the sidelines with regard to the broad S&P technology sector we continue to recommend a barbell portfolio approach preferring defensive software and services stocks to aggressive hardware and equipment equities. In that light, we reiterate our overweight stance in the key S&P software sub-industry that still commands the highest market cap weight in the tech sector just shy of 33%. While overall capex is sluggish as we highlighted above, software capital outlays have recovered smartly and according to national accounts are growing at a 10%/annum pace. Stock market-reported capex confirms that software capital expenditures are on an absolute tear and remain a key pillar of our secular preference for this defensive tech group (Chart 12). On the sales front, COVID-19 accelerated the push to the cloud and 2020 has been a bumper year for industry sales. True there is an element of stealing revenues from the future, but as long-time readers of our publication know we do not believe that SaaS is a fad and the adoption of cloud services remains in the early innings. Impressively, while relative forward top line growth expectations have rolled over, the attempt of the software price deflator to exit deflation suggests that software stocks will easily surpass this lowered revenue bar in coming quarters (Chart 13). Chart 12Primary Capex Beneficiary Primary Capex Beneficiary Primary Capex Beneficiary Amidst the IPO frenzy that has captured investors’ imagination especially given the spectacular increases in both SNOW and PLTR (neither of which is in the SPX yet), software M&A fever remains as high as ever. This constant reduction of software stock supply, coupled with the insatiable appetite of software executives to aggressively retire equity, signals that software equity prices will remain well bid (Chart 14). Chart 13Software Tries To Exit Deflation Software Tries To Exit Deflation Software Tries To Exit Deflation Chart 14Positive Share Price Dynamics Positive Share Price Dynamics Positive Share Price Dynamics Nevertheless, our relative EPS growth models are waving a yellow flag. The SPX is slated to grow profits north of 25% this year, but according to our profit models software will only manage to grow in the single digits, thus trailing the broad market by a wide margin. Encouragingly, this grim relative profit growth backdrop is already reflected in depressed sell side analysts’ forecasts (Chart 15). Finally, while relative valuations are still lofty they recently have corrected back to one standard deviation above the historical mean. Similarly, relative technicals have worked off overbought conditions and have settled down near the recent historical average (Chart 16). Chart 15Risks… Risks… Risks… In sum, rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Bottom Line: Continue to overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. Chart 16…To Monitor …To Monitor …To Monitor   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views January 12, 2021  Stay neutral small over large caps July 27, 2020 Overweight cyclicals over defensives (2.5% rolling stop) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Upgrading Utilities Upgrading Utilities Neutral We have been on the right side of the underweight utilities position for the better part of the past two years, but now that the easy money has been made, we are compelled to book handsome gains of 14.8% for the portfolio since inception and move to the sidelines. Extreme euphoria has taken over in the overall equity space and while the vaccine rollout news is a big positive, we doubt the ISM manufacturing survey reading can rise significantly from the current historically stretched level (ISM survey shown inverted, top panel). Similarly, junk yields are at all-time lows confirming that investor complacency is sky-high, and the USD very oversold with positioning stretched to the short dollars side. Any hiccups would cause all three of these macro indicators to reverse course abruptly, which would boost relative utilities share prices (middle & bottom panels). Bottom Line: We booked gains of 14.8% since inception in the S&P utilities sector and upgraded it from underweight to neutral. The ticker symbols for the stocks in this index are: BLBG: S5UTIL – NEE, D, DUK, SO, AEP, EXC, XEL, ES, SRE, WEC, AWK, PEG, ED, DTE, AEE, EIX, ETR, PPL, CMS, FE, AES, LNT, ATO, EVRG, CNP, NI, NRG, PNW. For more details, please refer to this Monday’s Strategy Report. ​​​​​​​

Highlights Portfolio Strategy Speculative fervor dominates trading in the S&P auto & components group, but soaring long-term profit projections, lofty valuations, overbought technicals, and a looming German/Japanese/Chinese BEV competitive attack on TSLA’s BEV home turf, all but guarantee some cooling off in the recent exuberance in this GICS2 industry group, and compel us to downgrade exposure to underweight. This move also pushes the S&P consumer discretionary sector to a below benchmark allocation, today. A firming operating backdrop, a stealthy turn in select macro data, extreme sell-side pessimism, bombed out technicals and compelling valuations all signal that it no longer pays to be bearish the S&P utilities sector. Upgrade to neutral.  Recent Changes Downgrade the S&P automobiles & components index to underweight, today. This move also pushes the S&P consumer discretionary sector to a below benchmark allocation, today. Upgrade the S&P utilities sector to neutral today, locking in gains of 14.8% since inception. Last Wednesday our rolling stop on the long “Back To Work”/short “COVID-19 Winners” pair trade got triggered and we booked gains of 21.5% since the September 8 inception. Table 1 Overdose? Overdose? Feature The SPX cheered Joe Biden’s inauguration and vaulted to fresh all-time highs last week. It is now at spitting distance from our 4,000 target, a mere 3.8% higher. While loose fiscal and easy monetary policies have staying power and will remain largely intact in 2021, their efficacy is dwindling. Crudely put, it would take additional extra-ordinary larger amounts of stimuli to move the needle, as all the good news and then some, is already reflected in fully valued stocks. Financial conditions are the easiest on record, as we highlighted recently, and investor complacency reigns supreme given the 0.34 print in the equity put/call ratio (Chart 1). Chart 1Complacency Reigns Complacency Reigns Complacency Reigns In the near-term, something’s got to give. Importantly, a rising number of indicators we track are flashing red. Not only is there a plethora of anecdotes that the newly minted stock traders using Robinhood are chasing story stocks armed with freshly-written stimulus checks, but margin debt is also exploding (Chart 2). Granted, the latter is a coincident indicator, nevertheless the stampede into stocks via tapping margin accounts is near previous cyclical zeniths: the annualized 13-week rate of change of margin debt uptake surpassed 100%/annum, a move last seen in 2007/2008 and 1999/2000 (Chart 2). Correcting margin debt for GDP and total stock market capitalization for the size of the US economy (Buffett Indicator) is revealing. Both measures are at an extreme using data going back to the 1970s, making the equity market susceptible to disappointment (Chart 3). Buyer exhaustion will come sooner rather than later, and such a dearth of buyers will cause at least an air pocket in stocks. Chart 2Maxed Out On Debt? Maxed Out On Debt? Maxed Out On Debt? Chart 3Off The Charts Off The Charts Off The Charts Moreover, there is an element of pre-GFC-type excesses, but now investors are speculating with equities instead of housing. Back then, NINJA loans, ARM loans and subprime loans in general were sustaining the house of cards as long as the price of the underlying asset kept on rising. As soon as prices crested and moved sideways to lower, debt deflation hit real estate speculators hard, especially ones that owned multiple homes. Currently, anecdotes of homeowners speculating on the stock market via Mortgage Equity Withdrawals (Greenspan-Kennedy MEW)1 are also mushrooming. In other words, many retail investors are tapping into their home equity and money saved from ultra-cheap re-financings and redeploying it into stocks. As of Q3/2020 MEW is running at the highest level since the GFC at $300bn or roughly 2% of disposable income; keep in mind that the latter has also gotten a COVID-19 fiscal boost to the order of $1.2tn, which makes the galloping MEW even more remarkable (Chart 4). Chart 4Even MEW Is Spiking Even MEW Is Spiking Even MEW Is Spiking While MEW is nowhere near its 2007/2008 peak, surely some of it is leaking into equities, beyond PCE, further fueling the recent stock market exuberance. Another indicator that has sprang to life of late is our Equity Capitulation Index. Back in March we used this indicator from a contrary perspective when we recommended investors go long equities on a cyclical basis (reason #16 to start buying equities). Subsequently we have remained cyclically exposed, but we cannot neglect the negative signal this indicator is now emitting: it has clawed back all the losses since March and is now at a level that has marked previous near-term tops, and at an eerily similar level as during the 2010 SPX peak (second panel, Chart 5). Further on the sentiment front, bulls are abundant, but bears have gone extinct: according to Investors Intelligence the bull/bear ratio is closing in on 4, an historically elevated ratio (Chart 6). Chart 5Contrary Alert: Bears Capitulated? Contrary Alert: Bears Capitulated? Contrary Alert: Bears Capitulated? Chart 6Extreme Sentiment Reading Extreme Sentiment Reading Extreme Sentiment Reading Netting it all out, speculative fervor has taken over the equity markets and at least a healthy near-term breather is warranted in order to consolidate recent impressive gains. We remain cautious on the short-term prospects of the broad equity market and continue to recommend investors go long a $390/$410 call spread on the SPY exchange traded fund financed by a short $340 put on the SPY for either March or June option expiries. This week, we downgrade a consumer goods index to underweight that is at the epicenter of the recent equity market bubble talk. This change also pushes the S&P consumer discretionary index to a below benchmark allocation. Further, we trigger our upgrade alert on a niche defensive sector monetizing sizable gains for the portfolio. Downgrade Autos & Components To Underweight We recommend investors shy away from the S&P automobiles & components GICS2 industry group, and today we downgrade it to an underweight stance. Before analyzing this group that has an 80%+ weight in TSLA in more detail, a couple of bubble-related observations are in order. The top panel of Chart 7 shows the google trends search term ‘stock market bubble’ as a time series, and it has hit all-time highs since the 2004 start in this data search query. Importantly, linking this to the SPX is instructive. Every time these search results pick up steam, so does S&P 500 momentum until it cracks. Assuming a sideways move from here onward on the S&P until the spring, it will boost year-over-year momentum to a peak over the 50%/annum mark (bottom panel, Chart 7). Using weekly data, the SPX has only managed such a feat three other times since WWlI, in 1983, in 1998 and in 2010 (as a reminder we drew SPX parallels to 1998 and 2010 earlier this month). True, this does not prove that the SPX is in a bubble per se, however it does highlight that it is overstretched and at risk of a snapback. While everyone was preoccupied with the effect TSLA’s SPX inclusion would have on the index’s 12-month forward P/E, the real change crept up in the long-term EPS growth expectations. This story stock caused the S&P 500’s five-year profit growth expectation to skyrocket from 12% to 21% overnight (top panel, Chart 8) and pushed down the S&P 500 forward P/E/G ratio to near par (not shown). Chart 7Bubble Talk Mushrooming Bubble Talk Mushrooming Bubble Talk Mushrooming Chart 8"It's too good for true, honey, it's too good for true" (Adventures of Huckleberry Finn, 1884), Mark Twain. "It's too good for true, honey, it's too good for true" (Adventures of Huckleberry Finn, 1884), Mark Twain. "It's too good for true, honey, it's too good for true" (Adventures of Huckleberry Finn, 1884), Mark Twain. Back in late-1999, YHOO’s SPX inclusion also caused a bump in this metric, but it paled in comparison to TSLA’s current dominance. In other words, nine percentage points of growth are attributed to a single stock or 43% of the SPX EPS growth is tied to the fortunes of TSLA. We highly doubt this will occur as analysts have been upgrading profit estimates and price targets for TSLA hand over fist over the past few months, with some using DCFs out to 2040 in order to back up their forecasts. Drilling deeper beneath the surface into the consumer discretionary sector is revealing. TSLA’s inclusion pushed the sector’s 5-year forward profit growth estimates to 83% (bottom panel, Chart 8). To put this in perspective it translates into consumer discretionary profits increasing 20 fold in the next 5 years; no, this is not a typo. Assuming that stock prices follow profits as it typically transpires, then prices will have to rise by a similar amount. Again, our sense is that this is highly unlikely. In comparison, AMZN’s graduation to the SPX in late-2005 barely budged this profit growth metric for the GICS1 sector as tech stocks were still licking their wounds from the dotcom bubble burst. One level lower into GICS2 territory and circling back to S&P auto & components, data series go fully parabolic, to a degree not seen even during the dotcom bubble era. The same aforementioned long-term growth rate zooms to over 300% for the S&P automobiles & components index compared with the broad market (Chart 9). Turning over to relative revenue expectations for the coming 12 months that data point surges close to 15% (middle panel, Chart 9). With regard to valuations, relative forward P/E, relative P/S and P/B are all in the stratosphere, warning that there is no valuation cushion to fall back on in case of an earnings mishap (Chart 10). Chart 9Dizzying… Dizzying… Dizzying… Chart 10...Heights ...Heights ...Heights Importantly, on the profit front, a wide gap has opened between relative share prices and relative forward EPS, which suggests that high-flying auto stocks will soon stop defying gravity (Chart 11). Technicals are also waving a red flag: the S&P autos & components relative annualized 13-week rate of change clocked in at over 250%/annum, steeply diverging from relative net EPS revisions (Chart 12). Chart 11Stocks Should Follow Profits Stocks Should Follow Profits Stocks Should Follow Profits Chart 12Cult Stock… Cult Stock… Cult Stock… Using the datastream index equivalent to the S&P automobiles & components (this data provider had included TSLA prior to the S&P’s inclusion in the S&P 500) reveals that this relative share price ratio is on a tear and warns investors that the S&P automobiles & components index is not as depressed as it first appears to the naked eye (Chart 13). Chart 13...Effect ...Effect ...Effect Looking at the single stock level, TSLA exemplifies the mania of the 2020s (bottom panel, Chart 14). This story stock has been moving in lockstep with M1 money supply. Such a breakneck pace of appreciation is clearly unsustainable (Chart 15). Chart 14TSLA Is A Mania TSLA Is A Mania TSLA Is A Mania Chart 15Spurious? Doubt It Spurious? Doubt It Spurious? Doubt It Finally, comparing TSLA to its global peers is also mind boggling. TSLA is worth a couple hundred billion US dollars more than all of the other global auto stocks put together (top panel, Chart 14)! Auto manufacturing is a cutthroat business with razor thin margins. Thus, we doubt that the German and Japanese (and lately even Chinese BEV makers) auto makers are not going to make inroads into TSLA’s BEV home turf. In Norway, the most advanced BEV market in the world, VW Group outsold TSLA last year by a factor of over 3-to-1. In sum, speculative fervor dominates trading in the S&P auto & components group, but soaring long-term profit projections, lofty valuations, overbought technicals, and a looming German/Japanese/Chinese BEV competitive attack on TSLA’s BEV home turf all but guarantee some cooling off in the recent exuberance in this GICS2 industry group. Bottom Line: Trim the S&P automobiles & components index to underweight today. This move also pushes the S&P consumer discretionary sector to a below benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AUCO – TSLA, GM, F, APTV, BWA. Act On The Utilities Upgrade Alert, Lock In Gains And Lift Exposure To Neutral We have been on the right side of the underweight utilities position for the better part of the past two years, but now that the easy money has been made we are compelled to book handsome gains of 14.8% for the portfolio since inception and move to the sidelines. The bearish story is well known on utilities and avoiding them is now a consensus trade. Chart 16 shows that when the economy is in expansion mode, it pays to minimize utilities exposure. The pendulum always swings the opposite direction and when the cycle matures, investors seek the safe haven stable cash flow status of this niche defensive sector. Extreme euphoria has taken over in the overall equity space and while the vaccine rollout news is a big positive, we doubt the ISM manufacturing survey reading can rise significantly from the current historically stretched level (ISM survey shown inverted, top panel, Chart 16). Similarly, junk yields are at all-time lows confirming that investor complacency is sky-high, and the USD very oversold with positioning stretched to the short dollars side. Any hiccups would cause all three of these macro indicators to reverse course abruptly, which would boost relative utilities share prices (Chart 16). Already, the CITI economic surprise index is sinking like a stone, equity market vol refuses to fall below 20, and the gap between the 10-year US Treasury (UST) yield and relative share prices remains historically wide, leaving ample room for utilities to catch up to the year-over-year drubbing in yields (yields shown inverted, top panel, Chart 17). In fact, were the broad equity market to correct as we expect in the near-term, there are high odds that the 10-year UST yield would fall, further boosting the allure of high yielding utilities. Chart 16Bearish Story Is Well Known Bearish Story Is Well Known Bearish Story Is Well Known Chart 17It No Longer Pays To Avoid Utilities It No Longer Pays To Avoid Utilities It No Longer Pays To Avoid Utilities On the operating front, nat gas prices have stopped hemorrhaging and as this least dirty fossil fuel gains broader investor acceptance in the new EV/ESG and responsible investing world, there is scope for utilities to reassert some of their lost pricing power. As a reminder, natural gas prices are the marginal price setter for utilities and the recent jump in momentum in the former is encouraging for utilities selling prices (second panel, Chart 18). Chart 18Positive Operating… Positive Operating… Positive Operating… Chart 19...Backdrop ...Backdrop ...Backdrop Moreover, industry inventories are whittled down and utilities construction has been receding, throughout last year (inventories shown inverted, top panel, Chart 19). In fact, it is contracting at roughly a 10%/annum pace (construction shown inverted, bottom panel, Chart 19). Taken together, it no longer pays to be overly bearish this niche defensive sector. Unsurprisingly, sell-side analysts have thrown in the towel and relative 12-month profit forecasts have plummeted, probing all-time lows near the negative 20% mark (third panel, Chart 18). Analyst pessimism is even more pronounced on the five-year outlook, with relative profit growth collapsing again near the negative 17% mark (bottom panel, Chart 18)! Granted this is a single stock’s effect as we showed in the previous section, with late-December TSLA inclusion to the index pushing the SPX long-term profit growth estimate to nearly 21%. We would lean against such pessimism. Finally, relative technicals and valuations also warn against staying negative on the prospects of the S&P utilities sector (Chart 20). Importantly, our Technical Indicator has fallen to one standard deviation below the historical mean, a level that has marked six countertrend up-moves in the past 25 years (bottom panel, Chart 20). Adding it all up, a firming operating backdrop, a stealthy turn in select macro data, extreme sell-side pessimism, bombed out technicals and compelling valuations all signal that it no longer pays to be bearish the S&P utilities sector. Bottom Line: Execute the upgrade alert and augment the S&P utilities sector to neutral today locking in gains of 14.8% since inception. The ticker symbols for the stocks in this index are: BLBG: S5UTIL – NEE, D, DUK, SO, AEP, EXC, XEL, ES, SRE, WEC, AWK, PEG, ED, DTE, AEE, EIX, ETR, PPL, CMS, FE, AES, LNT, ATO, EVRG, CNP, NI, NRG, PNW. Chart 20Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     https://www.federalreserve.gov/pubs/feds/2007/200720/200720pap.pdf Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views January 12, 2021  Stay neutral small over large caps October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives (Downgrade Alert) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade. But this perception is due to a singular focus on the economic slack component of the modern-day version of the curve to the exclusion of inflation expectations, and a failure to fully consider the lasting impact of sustained periods of a negative output gap on those expectations. In addition, many investors tend to downplay the long-term balance sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. The COVID-19 pandemic was certainly a major economic shock. But for now, it seems like this was a sharp income statement recession, not a balance-sheet recession. This fact, along with lower odds of negative supply-side shocks and several structural factors, suggest that inflation will be higher over the next ten years than it has over the past decade. Investors looking to protect against potentially higher inflation should look primarily to commodities, cyclical stocks, and US farmland. Gold is likely to remain well supported over the coming few years, but rich valuation suggests the long-term outlook for the yellow metal is poor. A hybrid TIPS/currency portfolio has historically been strongly correlated with the price of gold, and may provide investors with long-term protection against inflation – at a better price. Introduction Chart II-1A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations The pandemic, and the corresponding fiscal and monetary response is challenging the low-inflation outlook of many market participants. Chart II-1 highlights that long-dated market-based inflation expectations have surged past their pre-COVID levels after collapsing to the lowest-ever level in March. The shift in thinking about inflation has partly been a response to an extraordinary rise in government spending in many countries. But Chart II-1 shows that long-dated expectations in the US were mostly trendless from April to June as Federal support was distributed, and instead rose sharply in July and August in the lead-up to the Fed’s official shift to an average inflation targeting regime. This new dawn for US monetary policy has been prompted not just by the pandemic, but also by the extended period of below-target inflation over the past decade. In this report, we review how the past ten-year episode of low inflation can be successfully explained through the lens of the expectations-augmented (i.e. “modern-day”) Phillips Curve. Many investors fail to fully appreciate the impact that inflation expectations have on driving actual inflation, as well as the cumulative impact of two major capital and savings misallocations over the past 25 years on the responsiveness of demand to interest rates and on the level of inflation expectations. Using the modern-day Phillips Curve as a guide, we present several reasons in favor of the view that inflation will be higher over the next decade than over the past ten years. Finally, we conclude with an assessment of several ways for investors to protect their portfolios from rising inflation. Revisiting The “Modern-Day” Phillips Curve 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. Chart II-2Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve However, the experience of rising inflation alongside high unemployment from the late 1960s to the late 1970s underscored that prices are also importantly determined by inflation expectations and shocks to the supply-side of the economy (Chart II-2). In the 1980s and 1990s, the Federal Reserve’s success at reigning in inflation was achieved not only by raising interest rates to punishingly high levels, but also by sharply altering consumer, business, and investor expectations about future prices. The experience of the late 1960s and 1970s led to a revised form of the Phillips Curve, dubbed the “expectations-augmented” or “modern” version. As an equation, the modern Phillips Curve is described today by Fed officials, in terms of core inflation, as follows: πct = β1πet + β2πct-1 + β3πct-2 - β4SLACKt + β5IMPt + εt where: πct = Core inflation today πet = Expectations of inflation πct-n = Lagged core inflation SLACKt = Slack in the economy IMPt = Imported goods prices εt = Other shocks to prices Described verbally, this framework suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations.1” This framework can easily be extended to headline inflation by adding changes in food and energy prices. In most formal models of the economy in use today, the modern Phillips Curve is combined with the New Keynesian demand function to describe business cycles: Yt = Y*t – β(r-r*) + εt where: Yt = Real GDP Y*t = Real potential GDP r = The real interest rate r* = The neutral rate of interest εt = Other shocks to output This equation posits that differences in the real interest rate from its neutral level, along with idiosyncratic shocks to demand, cause real GDP to deviate from potential output. Abstracting from import prices and idiosyncratic shocks, these two equations tell a simple and intuitive story of how the economy generally works: The stance of monetary policy determines the output gap and, The output gap, along with inflation expectations, determine inflation. The Modern-Day Phillips Curve: The Pre-2000 Experience This above view of inflation and demand was strongly accepted by investors before the 2008 global financial crisis, but the decade-long period of generally below-target inflation has caused a crisis of faith in the idea of the Phillips Curve. Charts II-3 and II-4 show the historical record of the New Keynesian demand function and the modern-day Phillips Curve, using five-year averages of the data in question to smooth out the impact of short-term and idiosyncratic effects. We use nominal GDP growth as our long-run proxy for the neutral rate of interest,2 the US Congressional Budget Office’s (CBO) estimate of potential GDP to determine the output gap, and a proprietary measure of inflation expectations based on an adaptive expectations framework3 (Chart II-5). Chart II-3With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 Chart II-4Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Chart II-3 shows that until 1999, the stance of monetary policy was highly predictive of the output gap over a five-year period, with just two exceptions where major structural forces were at play: the late 1970s, and the second half of the 1990s. In the case of the former, the disruptive effect of persistently high inflation negatively impacted output growth despite easy monetary policy, and in the latter case, economic activity was modestly stronger than what interest rates would have implied due to the beneficial impact of the technologically-driven productivity boom of that decade. Similarly, Chart II-4 shows that until 1999 there was a good relationship between the output gap and the deviation in inflation from expectations, again with the late 1970s and late 1990s as exceptions. Along with the beneficial supply-side effects of the disinflationary tech boom, persistent import price weakness (via dollar strength) seems to have also played a role in suppressing inflation in the late 1990s (Chart II-6). Chart II-5The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized Chart II-6A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s   The Modern-Day Phillips Curve Post-2000 Following 2000, deviations between the monetary policy stance, the output gap, and inflation become more prominent, particularly after 2008. As we will illustrate below, these deviations are more apparent on the demand side. In the case of inflation, the question should be why inflation was not even lower in the years immediately following the global financial crisis. On both the demand and inflation side, these deviations are explainable, and in a way that helps us determine future inflation. Charts II-7 and II-8 show the same series as in Charts II-3 and II-4, but focused on the post-2000 period. From 2000-2007, Chart II-8 shows that the relationship between the output gap and the deviation in inflation from expectations was not particularly anomalous. The output gap was negative from the end of the 2001 recession until the beginning of 2006, and inflation was correspondingly below expectations on average for the cycle. Chart II-7Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Chart II-8Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong   Chart II-7 shows that the anomaly during that cycle was in the relationship between the output gap and the stance of monetary policy. Monetary policy was the easiest it had been in two decades, yet the output gap was negative for several years following the recession. Larry Summers pointedly cited this divergence in his revival of the secular stagnation theory in November 2013, arguing that it was strong evidence that excess savings were depressing aggregate demand via a lower neutral rate of interest and that this effect pre-dated the financial crisis. Why was demand so weak during that period? Chart II-9 compares the annualized per capita growth in the expenditure components of GDP during the 2001-2007 expansion to the 1991-2001 period. The chart shows that all components of GDP were lower than during the 1991-2001 period, with investment – the most interest rate sensitive component of GDP – showing up as particularly weak. On the surface, this supports the idea of structural factors weighing heavily on the neutral rate, rendering monetary policy less easy than investors would otherwise expect. But Chart II-9 treats the 2001-2007 years as one period, ignoring what happened over the course of the expansion. Chart II-10 repeats the exercise shown in Chart II-9 from Q1 2001 to Q3 2005, and highlights that the annualized growth in per capita residential investment was much stronger than it was during the 1991-2001 period – and nonresidential fixed investment was much weaker. Spending on goods was roughly the same, which is impressive considering that the late 1990s experienced a productivity boom and robust wage growth. All the negative contribution to growth from residential investment during the 2001-2007 expansion came after Q3 2005, as the housing market bubble burst in response to rising interest rates. In short, Chart II-10 highlights that there was a strong relationship between easy monetary policy and the demand for housing, but that this was not true for the corporate sector. Chart II-9Looking At The Whole 2001-2007 Period, Investment Was Extremely Weak January 2021 January 2021 Chart II-10Housing Absolutely Responded To Easy Monetary Policy January 2021 January 2021   Explaining Weak CAPEX Growth In The Early 2000s This leads us to ask why CAPEX was so weak during the 2001-2007 period. In addition to changes in interest rates, business investment is strongly influenced by expectations of consumer demand and corporate profitability. Chart II-11 shows that real nonresidential fixed investment and as-reported earnings moved in lockstep during the period, and that this delayed corporate-sector recovery also impacted the pace of hiring. Weak expectations for consumer spending do not appear to be the culprit. Chart II-12 highlights that while real personal consumption expenditure growth fell during the recession, spending did not contract (as it had done during the previous recession) and capital expenditures fell much more than what real PCE would have implied. Chart II-11Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Chart II-12CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending   Instead, persistently weak CAPEX in the early 2000s appears to be best explained by the damaging impact of corporate excesses that built up during the dot-com bubble. The Sarbanes-Oxley Act of 2002 was passed in response to a series of corporate accounting frauds that came to light in the wake of the bubble, but in many cases had been occurring for several years. Chart II-13 highlights that widespread write-offs badly impacted earnings quality and the growth in the asset value of equipment and intellectual property products (IPP), both of which only began to improve again in early 2003. This occurred alongside an outright contraction in real investment in IPP as investors lost faith in company financial statements and heavily scrutinized corporate spending. Chart II-14highlights that a contraction in IP spending was a huge change from the double-digit pace of growth that occurred in the late 1990s. Chart II-13The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses Chart II-14A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble   In addition, corporate sector indebtedness also appears to have played a role in driving weak investment in the early 2000s. While the interest burden of nonfinancial corporate debt was not as high in 2000 as it was in the early 1990s, Chart II-15 highlights that debt to operating income surged in the late 1990s – which likely caused investors already skeptical about company financial statements to impose a period of elevated capital discipline on corporate managers following the recession. Chart II-16 shows that while the peak in the 12-month trailing corporate bond default rate in January 2002 was similar to that of the early 90s, it was meaningfully higher on average in the lead-up to and following the recession. Chart II-15The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt Chart II-16Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession   To summarize, Charts II-10-16 underscore that management excesses, governance failures, and elevated debt in the corporate sector in the 1990s were the root cause of the seeming divergence between monetary policy and the output gap from 2001 to 2007. This was, unfortunately, the first of two major savings/capital misallocations that have occurred in the US over the past 25 years. Explaining The Post-GFC Experience In the early 2000s, the Federal Reserve was faced with a decision between two monetary policy paths: one that was appropriate for the corporate sector, and one that was appropriate for the household sector. The Fed chose the former, and it inadvertently contributed to the second major savings/capital misallocation to occur over the past 25 years: the enormous debt-driven bubble in US housing that culminated into the global financial crisis (GFC) of 2007-2009. Chart II-17It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle As a result, 2007 to 2013/2014 was a mirror image of the early 2000s. Unlike previous post-war downturns, the GFC precipitated a balance-sheet recession that deeply affected homeowners and the financial system. This lasting damage led to a multi-year household deleveraging process, which substantially lowered the responsiveness of the economy to stimulative monetary policy. On a year-over-year basis, Chart II-17 shows that total nominal household mortgage credit growth was continuously negative for six and a half years, from Q4 2008 until Q2 2015, underscoring that the large divergence during this period between the stance of monetary policy and the output gap should not, in any way, be surprising to investors. And this is even before accounting for the negative impact of the euro area sovereign debt crisis and double-dip recession, or the persistent fiscal drag in nearly every advanced economy last cycle. What is surprising about the post-GFC experience is that inflation was not substantially weaker than it was, which is ironic considering that the secular stagnation narrative was revived to help explain below-target inflation. Chart II-8 showed that actual inflation steadily improved versus expected inflation alongside the closing of the output gap and the decline in the unemployment rate, but that it was much stronger than the output gap would have implied – particularly during the early phase of the economic recovery. It is still an open question as to why this occurred. A weak dollar and a strong recovery in oil prices likely helped support consumer prices, but we doubt that these two factors alone explain the discrepancy. A more credible answer is that expectations stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. For example, in a CBS interview following the Fed’s November 2010 decision to engage in a second round of quantitative easing (“QE2”), then-Chair Bernanke prominently tied the decision to the fact that “inflation is very, very low.” When asked whether additional rounds of easing might be required, Bernanke responded that it was “certainly possible” and again cited inflation as a core consideration. Chart II-18Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock While inflation did not ultimately fall relative to expectations post-GFC as much as the output gap would have implied, the long-lasting weakness in demand left expectations vulnerable to exogenous shocks. In 2014, such a shock occurred: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-18), a level of output that many experts had previously believed would not be attainable (or would roughly mark the peak in production). We view this event as a truly exogenous shock to prices, given that research & development of shale technology had been ongoing since the late 1970s and only happened to finally gain traction around 2010. Chart II-19 shows that the 2014 oil price collapse caused a clear break lower in our measure of inflation expectations, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-20). This decline in inflation expectations meant that the output gap needed to be above zero in order for the Fed to hit its 2% target (absent any upwards shock to prices), and that the meaningful acceleration of inflation from 2016 to 2018 should actually be viewed as inflation “outperformance” because its long-term trend had been lowered by the earlier downward shift in expectations. Chart II-19The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... Chart II-20...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used   The Modern-Day Phillips Curve: Key Takeaways Based on the evidence presented above, we see the perceived “failure” of the Phillips Curve to predict weak inflation over the past decade as being due to: A singular focus on the output gap/slack component of the modern Phillips Curve, to the exclusion of expectations A failure to fully consider the lasting impact of sustained periods of a negative output gap on expectations Downplaying the long-term balance-sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. One crucial takeaway from the modern-day Phillips Curve equation presented above 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. The extended period of below-potential output over the past two decades, accelerated recently by a major negative shock to energy prices, has now lowered inflation expectations to a point that merely reaching the Fed’s target constitutes inflation “outperformance.” This realization, made even more urgent by the COVID-19 pandemic, has strongly motivated the Fed’s official shift to an average inflation targeting regime. That shift does not suggest that the Fed is moving away from the modern-day Phillips Curve framework; rather, the Fed’s new policy is aimed at closing the output gap as quickly as possible in order to prevent a renewed decline in inflation expectations (and thus inflation itself) from another long period of activity running below its potential. The Outlook For Inflation While the Fed has shifted its policy to prefer higher inflation, that does not necessarily mean it will get it. Why is it likely to happen this time, if the last economic cycle featured such a large divergence between monetary policy and the output gap? Chart II-21Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent First, to clarify, we do not believe that above-target inflation is imminent. The COVID-19 pandemic was an extreme event, and even given the very substantial recovery in the labor market, the unemployment rate remains almost 2½ percentage points above the Congressional Budget long-run estimate of NAIRU (Chart II-21). But based on our analysis of the modern-day Phillips Curve presented above, there are at least four main reasons to expect that inflation may be higher on average over the next ten years than over the past decade. Reason #1: This Appears To Be A Sharp Income Statement Recession, Not A Balance-Sheet Recession We highlighted above the importance of savings/capital misallocations in driving a gap between monetary policy and the output gap over the past two decades, but this recession was obviously not sparked by such an event. The onset of the pandemic came following a long period of US household sector deleveraging which, while painful, helped restore consumer balance sheets. Chart II-22 highlights that household debt to disposable income had fallen back to 2001 levels at the onset of the pandemic, and the interest burden of debt servicing had fallen to a 40-year low. From a wealth perspective, Chart II-23 highlights that total household liabilities to net worth have fallen below where they were at the peak of the housing market boom in 2005 for almost all income groups, and that a decline in leverage has been particularly noteworthy for the lowest income group since mid-2016. Chart II-22Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Chart II-23...Across Almost All Income Brackets ...Across Almost All Income Brackets ...Across Almost All Income Brackets   Total credit to the nonfinancial corporate sector rose significantly relative to GDP over the course of the last cycle, but subpar growth in real nonresidential fixed investment and a rise in share buybacks highlight that this debt went largely to fund changes in capital structure rather than increased productive capacity. Chart II-24 highlights that corporate sector interest payments as a percentage of operating income are low relative to history, and they do not seem to be necessarily dependent on extremely low government bond yields.4 Finally, the corporate bond default rate may have already peaked (Chart II-25) and the percentage of jobs permanently lost looks more like 2001 than 2007 (Chart II-26), signaling that a prolonged balance-sheet recession is unlikely. Chart II-24Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Chart II-25Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Chart II-26So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 The bottom line is that while the pandemic has not yet been resolved and that major and permanent economic damage cannot be ruled out, the absence of “balance-sheet dynamics” is likely to eventually lead to a stronger responsiveness of demand for goods and services to what is set to be an extraordinarily easy monetary policy stance for at least another two years. Reason #2: The Fed May Be Able To Jawbone Inflation Higher The Fed’s public commitment to set interest rates in a way that will generate moderately above-target inflation is highly reminiscent of its defense of quantitative easing in the early phase of the last economic expansion, and (in the opposite fashion) of Paul Volker’s campaign in the 1980s against the “self-fulfilling prophecy” of inflation. From 2008-2014, the Fed explicitly linked the odds of future bond buying to the pace of actual inflation in its public statements. On its own, this was not enough to cause inflation to rise, but we highlighted above that it may have contributed to the fact that inflation expectations did not collapse. Chart II-1 on page 12 showed that long-dated market-based expectations for inflation have already been impacted by the Fed’s regime shift, suggesting decent odds that Fed policy will contribute to self-fulfilling price increases if the US economy does indeed avoid “balance-sheet dynamics” as a result of the pandemic. Reason #3: The Odds Of Negative Supply Shocks Are Lower Than In The Past We noted above the impact that energy price shocks and large typically exchange-rate driven changes in import prices can have on inflation, with the 2014 oil price collapse serving as the most vivid recent example. On both fronts, a value perspective suggests that the odds of negative shocks to inflation over the coming few years from oil and the dollar are lower than they have been in the past. Chart II-27 shows that the cost of global energy consumption as a share of GDP has fallen below its median since 1970, and Chart II-28 highlights that the US dollar is comparatively expensive relative to other currencies – which raises the bar for further gains. Stable-to-higher oil prices alongside a flat-to-weak dollar implies reflationary rather than disinflationary pressure. Chart II-27Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Chart II-28Valuation Favors A Declining Dollar, Which Is Inflationary January 2021 January 2021   Reason #4: Structural Factors In addition to the cyclical arguments noted above, my colleague Peter Berezin, BCA’s Chief Global Strategist, has also highlighted several structural arguments in favor of higher inflation. Chart II-29 highlights that the world support ratio, calculated as the number of workers relative to the number of consumers, peaked early last decade after rising for nearly 40 years. This suggests that output will fall relative to spending the coming several years, which should have the effect of boosting prices. Chart II-30 also highlights that globalization is on the back foot, with the ratio of trade-to-output having moved sideways for more than a decade. Since the early 1990s, rising global trade intensity has corresponded with very low goods prices in many countries, and the end of this trend reduces the impact of a factor that has been weighing on consumer prices globally over the past two decades. Chart II-29Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Chart II-30Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To   Positioning For Eventually Higher Inflation Below we present an assessment of several potential candidates across the major asset classes that investors can use to protect their portfolios from rising inflation once it emerges. We conclude with a new trade idea that may provide investors with inflation protection at a better valuation profile than more traditional inflation hedges. Fixed-Income Within fixed-income, inflation-linked bonds and derivatives (such as CPI swaps) are the obvious choice for investors seeking inflation protection. Inflation-linked bonds are much better played relative to nominal equivalents, as inflation expectations make up the difference between nominal and inflation-linked yields. But Table II-1 shows that 5-10 year TIPS are also likely to provide positive absolute returns over the coming year even in a scenario where 10-year Treasury yields are rising, so long as real yields do not account for the vast majority of the increase. Barring a major and positive change in the long-term economic outlook over the coming year, our sense is that the Fed would act to cap any outsized increase in real yields and that TIPS remain an attractive long-only option until the Fed becomes sufficiently comfortable with the inflation outlook. Table II-1TIPS Will Earn Positive Absolute Returns Next Year Barring A Surge In Real Yields January 2021 January 2021 Commodities Commodities are arguably the most traditional inflation hedge, and are likely to provide investors with superior risk-adjusted returns in an environment where inflation expectations are rising. Our Commodity & Energy Strategy service is positive on gold, and recently argued that Brent crude prices are likely to average between $65-$70/barrel between 2021-2025.5 Chart II-31Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor One caveat about gold is that, unlike oil prices, it appears to be quite expensive relative to its history. Since gold does not provide investors with a cash flow, over time real (or inflation-adjusted) prices should ultimately be mean-reverting unless real production costs steadily trend higher. Chart II-31 highlights that the real price of gold is already sky-high and well above its historical average. Over a ten-year time horizon, gold prices fell meaningfully following the last two occasions where real gold prices reached current levels, suggesting that the long-term outlook for gold returns is poor. However, over the coming few years, gold prices are likely to remain well supported given our economic outlook, the Fed’s new monetary policy regime, and the consistently negative correlation between real yields and the US dollar and gold prices. As such, we would recommend gold as a hedge against the fear of inflation, which is likely to increase over the cyclical horizon. Equities We provide two perspectives on how equity investors may be able to protect themselves against rising inflation. The first is simply to favor cyclical versus defensive sectors. The former is likely to continue to benefit next year in response to a strengthening economy as COVID-19 vaccines are progressively distributed, and historically cyclical sectors have tended to outperform during periods of rising inflation. In addition, my colleague Anastasios Avgeriou, BCA’s Equity Strategist, presented Table II-2 in a June Special Report,6 and it highlights that cyclical sectors (plus health care) have enjoyed positive relative returns on average during periods of rising inflation. Table II-2S&P 500 Sector Performance During Inflationary Periods January 2021 January 2021 The second strategy is to favor companies that are more likely to successfully pass on increasing prices to their customers (i.e., firms with “pricing power”). Pricing power is a difficult attribute to identify, but one possible approach is to select industries that have experienced above-average sales per share growth over the past decade. While it is true that the past ten years have seen low rather than high inflation, it has also seen firms in general struggle to achieve robust top-line growth. Industries that have succeeded in this environment may thus be able to pass on higher costs to their customers without disproportionately suffering from lower sales. Chart II-32Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Chart II-32 presents the historical relative performance of these industries in the US plus the materials and energy sector, equally-weighted and compared to an equally-weighted industry group portfolio (level 2 GICS). The chart shows that the portfolio has outperformed steadily over the past decade, although admittedly at a slower pace since 2018. An interesting feature of this approach is that, in addition to including industries within the industrials, consumer discretionary, and health care sectors (along with the food & staples retailing component of the consumer staples sector), tech stocks show up prominently due to their outstanding revenue performance over the past decade. Table II-2 above highlighted that tech stocks have historically performed poorly during periods of rising inflation, although it is unclear whether this is due to increasing prices or expectations of rising interest rates. Tech stocks are typically long-duration assets, meaning that they are very sensitive to the discount rate, but the Fed’s new monetary policy regime all but guarantees that investors will see a gap between inflation and rates for a time. It is thus an open question how tech stocks would perform in the future in response to rising inflation, and we plan to revisit this topic in a future report. Chart II-33Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies As a final point within the stock market, we would caution against equity portfolios favoring companies that are owners or operators of infrastructure assets. While increased infrastructure spending may indeed occur in the US over the coming several years, indexes focused on companies with sizeable existing infrastructure assets tend to be highly concentrated in the utilities and telecommunications sectors. Chart II-33 shows that the relative performance of the MSCI ACWI Infrastructure Index is nearly identical to that of a 50/50 utilities/telecom services portfolio, two sectors that are defensive rather than pro-cyclical and that have historically performed poorly during periods of rising inflation. Direct Real Estate Alongside commodities, direct real estate investment is also typically viewed as a traditional inflation hedge. For now, however, the outlook for important segments of the commercial real estate market is sufficiently cloudy that it is difficult to form a high conviction view in favor of the asset class. CMBS delinquency rates on office properties have remained low during the pandemic, but those of retail and accommodation have soared and the long-term outlook for all three may have permanently shifted due to the impact of the pandemic. By contrast, industrial and medical properties are likely to do well, with the former likely to be increasingly negatively correlated with the performance of retail properties in the coming few years (i.e., “warehouses versus malls”). I noted my colleague Peter Berezin’s structural arguments for inflation above, and Peter has also highlighted farmland as a real asset that is likely to do well in an environment of rising inflation.7 Chart II-34 further supports the argument: the chart shows that despite a significant increase in real farm real estate values over the past 20 years, returns to operators as a % of farmland values are not unattractive. In addition, USDA forecasts for 2020 suggest that operator returns will be the highest in a decade relative to current 10-year Treasury yields, underscoring both the capital appreciation and relative yield potential of US farmland. A Hybrid TIPS/Currency Inflation-Hedged Portfolio Finally, as we highlighted in Section 1, in a world of extremely low government bond yields, global ex-US investors have the advantage of being able to hedge against deflationary risks in a long-only portfolio by employing the US dollar as a diversifying asset. The dollar is consistently negatively correlated with global stock prices, and this relationship tends to strengthen during crisis periods. The flip side is that US-based investors have the advantage of being able to hedge against inflationary risks in a long-only portfolio by buying global currencies. Chart II-35 presents a 50/50 portfolio of US TIPS and an equally-weighted basket of six major DM currencies against the US dollar. The chart highlights that the portfolio is strongly positively correlated with gold prices, but with a better valuation profile. We already showed in Chart II-28 on page 28 that global currencies are undervalued versus the US dollar. TIPS valuation is not as attractive given that real yields are at record low levels, but the 10-year TIPS breakeven inflation rate currently sits at its 40th percentile historically (and thus has room to move higher). Chart II-34Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Chart II-35A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold   As such, while gold prices are likely to remain supported over the cyclical horizon, a hybrid TIPS/currency portfolio may also provide investors with long-term protection against inflation – at a better price. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 “Inflation Dynamics and Monetary Policy,” Janet Yellen, Speech at the Philip Gamble Memorial Lecture, University of Massachusetts - Amherst, Amherst, Massachusetts, September 24, 2015. 2 The use of nominal GDP growth as our proxy for the neutral rate of interest is based on the idea that borrowing costs are stimulative if they are below that of income growth. 3 An adaptive expectations framework suggests that expectations for future inflation are largely determined by what has occurred in the past. Our proxy for inflation expectations is thus calculated using simple exponential smoothing of the actual PCE deflator, which provides us with a long and consistent time series for expectations. 4 The second debt service ratio shown in Chart II-24 would only rise to its 68th historical percentile if the 10-year Treasury yield were to rise to 3%, or the 75th with a 10-year yield at 4%. This would be elevated relative to history, but not extreme. 5 Please see Commodity & Energy Strategy Report “BCA’s 2021-25 Brent Forecast: $65-$70/bbl,” dated November 12, 2020, available at ces.bcaresearch.com 6 Please see US Equity Strategy Special Report “Revisiting Equity Sector Winners And Losers When Inflation Climbs,” dated June 1, 2020, available at uses.bcaresearch.com 7 Please see Global Investment Strategy Weekly Report “Will There Be A Fiscal Hangover?” dated May 29, 2020, available at gis.bcaresearch.com