Europe

Highlights The combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency for the Fed to raise interest rates. The central bank’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, and it will move forward with a rate hike at its March meeting. We expect that the Fed funds rate will rise to 1% by the end of this year. The Fed’s asset purchase reductions will not have a direct impact on economic activity, but they could have an indirect effect by prompting a faster rise in US Treasury yields towards their fair value levels. The US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year, rather than by the end of 2022 as we previously expected. Part of the generalized rise in risk premia this month relates to the potential Russian invasion of Ukraine, but the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates. Rising long-maturity bond yields are being driven by the short end of the curve, which we see as a sign that the generalized selloff in the US equity market is uncalled for. Investors should buy the US stock market at current levels on a 6-12 month time horizon. It is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. A Russian invasion of Ukraine has become a likely event, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but investors should gird for a risk-off reaction over shorter-term time horizons. Omicron, The Supply-Side, And The Fed January was a poor month for the global equity market, which sold off 10% from its high at the beginning of the year. Chart I-1 highlights that in the US, the S&P 500 has now fallen below its 200-day moving average, in contrast to global ex-US stocks which have fared somewhat better in US$ terms. Equities have declined this month because of a combination of imminent Fed tightening and a geopolitical crisis, both of which we will discuss in detail below. On the pandemic front, the number of confirmed cases of COVID-19 has surged globally (Chart I-2), which is likely an underestimation of the total number of infections given capacity limits on testing in many countries. Panel 2 highlights that services PMIs fell sharply in January in several economies because of the Omicron wave, reflecting both renewed pandemic control measures in some countries as well as precautionary changes in behavior amongst consumers in countries where widespread “non-pharmaceutical interventions” (“NPIs”) were not reintroduced. Manufacturing PMIs, on the other hand, held up quite well, even in Europe where natural gas prices remain high. Chart I-1A Significant Correction In US Stock Prices Chart I-2Omicron Is Impacting Services, Not Manufacturing   Some positive signs have emerged from the hospitalization data in advanced economies, as they appear to be pointing to a cresting wave of patients with COVID-19 both in hospitals overall and specifically in intensive care units (Chart I-3). The evolution of the pandemic remains highly uncertain, and the development of new variants continues to remain a risk. But incoming data on hospitalizations, the rapid increase in the number of vaccine booster doses administered in many advanced economies, and the sheer speed at which the disease has recently been spreading all point to a possible imminent peak in the impact of the Omicron variant on the demand side of the economy – at least in the developed world. However, Chart I-4 highlights that there is no sign yet of a waning impact of the pandemic on the supply side of the economy. The chart shows that rising European natural gas prices are having less of an impact on our supply-side pressure indicator, but that the indicator remains flat excluding this effect. We noted in last month’s report that the Omicron variant posed a significant risk of more frequent or longer lockdowns in China, because of the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to provide any protection against contracting Omicron. Panel 2 of Chart I-4 highlights that shipping costs between China/East Asia and the west coast of the US have started to tick higher again, suggesting that the impact of ongoing lockdowns as well as mandatory quarantines and testing in key areas such as Shenzhen, Tianjin, Ningbo, and Xi’an may already be having an effect. Chart I-3Hospitalizations From Omicron Appear To Be Peaking Chart I-4Pandemic-Related Supply-Side Pressures Remain Severe   From the Fed’s perspective, a combination of a temporarily negative domestic demand effect and a lingering domestic labor and global supply chain effect from the Omicron variant has increased the urgency to raise interest rates. The Fed’s credibility has been significantly challenged over the past year by the extent of the rise in consumer prices, which is being partially driven by demand (even if supply-chain factors are also materially boosting global goods prices). Chart I-5The Odds Of Extreme US Inflation Are Falling, But Inflation Will Still Be High This Year Chart I-5 shows that our inflation momentum model is signaling falling odds of 4% or higher core PCE inflation, but the model’s probability remains above the 50% mark. Thus, while it is possible that US inflation will soon peak in year-over-year terms, the Fed will move forward with a rate hike at its March meeting. For now, we believe that the Fed will move at a pace of four quarter-point rate hikes per year (regardless of how they are sequenced), suggesting that the effective Fed funds rate will rise to 1% by the end of this year. Quantitative Tightening And Financial Markets Investors continue to wrestle with the Fed’s recent hawkish shift and the implications that it may have for economic activity and financial markets. Investors are not just concerned about the pace and magnitude of Fed rate hikes, but also the potential impact of quantitative tightening as the Fed moves to slow the pace of its asset purchases over the coming few months. Chart I-6The Correlation Between The Fed's Balance Sheet And The Equity Market Is Mostly A Spurious one In our view, investors should be more concerned with the former rather than the latter. Chart I-6 highlights the reason that investors were so focused on the magnitude of the Fed’s balance sheet during the first half of the last economic expansion. Panel 1 of the chart shows that the level of the S&P 500 correlated almost perfectly with the Fed’s total holdings of securities from 2008 to 2015. However, panel 2 highlights that this relationship broke down from 2016 to early 2020, only to correlate positively again as the Fed’s holdings of securities surged higher during the pandemic. To us, the experience of the past decade highlights that the correlation between the Fed’s balance sheet and the equity market is mostly a spurious one. The two are indirectly related; periods when the Fed’s security holdings increase reflect periods of monetary easing, which is typically positive for risky asset prices. But we do not agree that the impact of asset purchases on long-maturity bond yields can be effectively separated from the direct impact of changes in short-term interest rates, which are typically falling as the Fed’s balance sheet rises. In addition, asset purchases signal important information by the Fed about the future path of short-term interest rates when it changes the pace of its purchases. And finally, the 2016-2019 period strongly underscores that there is no direct link between Fed asset purchases and the stock market. It is possible that periods of rising Fed asset purchases are associated with a low government bond term premium or more dovish investor sentiment about the future path of interest rates than is projected by the Fed. If so, that could imply that the Fed’s asset purchase reductions will have some impact on financial markets over the coming months. Chart I-7 suggests that the term premium on 10-year Treasurys is no longer low, but these series are based on surveys of primary dealers and fixed-income market participants, and thus may not reflect the aggregate views of investors. Chart I-8 highlights that 10-year government bond yields are 40 basis points below the fair value implied by the Fed’s interest rate projections, and panel 2 highlights a similar conclusion based on a regression of the 10-year yield on the 2-year yield and 5-year/5-year forward CPI swap rates. Thus, it is possible that the Fed’s rapid reduction in the pace of its asset purchases will cause bond yields to converge quickly with these estimates of fair value, implying that the US 10-year yield could potentially rise to 2.3-2.4% at some point in the first half of the year rather than by the end of 2022, as we previously expected. Chart I-7Surveys Suggest The Term Premium Is No Longer Deeply Negative... Chart I-8...But 10-Year Treasury Yields Are Lower Than They Should Be The Stock Market, Interest Rates, And Value Versus Growth Chart I-9The US Equity Market Selloff Has Been Driven By Tech Stocks The fact that the global equity selloff had been concentrated in the US prior to the escalation in tensions over Ukraine reveals the root cause of the decline. Chart I-9 highlights that the Nasdaq has fallen more than the S&P 500, as have US growth stocks compared with value stocks. As such, the recent selloff in the stock market reflects some of the major themes that we presented in our 2022 annual outlook. We highlighted in our outlook, as well as several previous reports, that the relative performance of global growth versus value since the pandemic has been driven primarily by changes in valuation that could reverse if bond yields rose. Chart I-10 highlights that this is exactly what has occurred over the past month, which also explains the underperformance of US equities given how heavily-weighted the US market is toward broadly-defined technology stocks. However, the underperformance of US growth stocks has occurred within the context of a nontrivial decline in the overall US market, which was somewhat beyond our expectation. We anticipated a period of elevated financial market volatility in advance of the Fed’s first rate hike, and we warned investors that 2022 was likely to be a year of meaningfully lower total returns (mid-to-high single digits) compared with the past two years. The fact that equity multiples for growth stocks are falling in response to higher long-maturity bond yields is not surprising to us. But investors have punished both growth and value stocks as bond yields have risen, behavior that we do not think is justified given the large difference in valuation between the two. Chart I-11 highlights that our (standardized) proxy for the equity risk premium (ERP) is above its 2003-2021 average for value stocks, whereas it is quite low for growth stocks. Had the ERP for value stocks fallen to its historical average this month value stocks would have risen between 1-4% in January despite rising real 10-year government bond yields. And the historically average levels shown in Chart I-11 might themselves be too high, given that other ERP estimates like the ones we showed in our annual outlook highlight that the 2003-2021 period was one in which the US ERP was historically elevated. Chart I-10Value Is Outperforming Growth As Bond Yields Rise, As We Predicted In Our Annual Outlook Chart I-11The ERP For Value Stocks Does Not Need To Rise Chart I-12The Market Is Not Yet Pricing An End To Secular Stagnation, Which Is Good For Stocks As noted, part of a generalized rise in the ERP this month relates to the potential Russian invasion of Ukraine, an event that we now see as likely (discussed below). But the sell-off in equity prices also appears to reflect an overall level of investor discomfort with rising interest rates, particularly given the (mistaken) perception amongst investors that Fed hawkishness is entirely driven by elevated inflation. We acknowledge that the Fed’s hawkish shift has been a rapid one, and that this has led US government bond yields to rise quickly. Both the level and change in interest rates matter for economic activity and financial market sentiment, but our view is that the former is more important. Changes in interest rates are mainly significant because they create uncertainty about where rates will ultimately settle, and whether that level would be sustainable for economic activity and the valuation of financial assets. In this respect, Chart I-12 should be encouraging for investors. The chart shows that the 10-year Treasury yield recently reached a new pandemic high, but that this rise was driven by yields on shorter-maturity bonds. 5-year/5-year forward Treasury yields remain 50 basis points below the Fed’s long-term Fed funds rate projection (2.5%), suggesting that the rapid move in US Treasury yields simply reflects a revised pace of rate hikes – not ultimately a higher level. This underscores that the generalized selloff in the US equity market is uncalled for, and that investors should buy the US stock market at current levels. Chart I-13Recession Fears May Rise Early Next Year Chart I-13 highlights that an accelerated pace of rate hikes will likely cause the yield curve to be flatter at the end of the year than would have otherwise been the case, which may eventually be interpreted by investors as a sign that a recession is drawing nearer (potentially implicating both value and growth stocks). We discussed this risk in last month’s report, but for now we maintain the view that this is more likely to occur in 2023 rather than this year. The chart highlights that the S&P 500 did not sell off in response to growth/recession concerns in 2018 before the 2/10 yield curve had flattened to 20-30 basis points, which isn’t likely to occur until 1H 2023 according to fair value calculations derived from the FOMC’s rate projections. The Dollar, Chinese Policy, Commodities, And Global Ex-US Stocks Chart I-14Until This Week, The Dollar Had Been Trending Lower Despite Ostensibly Bullish Dollar Factors Despite the recent surge in US interest rate expectations, and up until last week, the US dollar had behaved in a somewhat strange fashion since late November– even as the Omicron variant spread rapidly around the globe. Chart I-14 highlights that the dollar had traded counter to both relative interest rate differentials and the intensity of the pandemic, both of which appear to have strongly explained the dollar’s trend in the first three quarters of 2021. As we go to press, the US dollar is rallying again, although at least some of the rise is being driven by the prospect of imminent war in Ukraine. We argued in our annual outlook that the dollar was likely to fall this year, and that it was both technically stretched and expensive according to our PPP models. Chart I-15 highlights that the prior weakness in the dollar may also be explained by slowing net foreign purchases of US equities, as the impact of global equity investors flocking to the tech-heavy US market during the pandemic begins to wane. However, we suspect that two additional factors may have been impacting the broad dollar trend before this week’s surge in geopolitical risk. The first is a possible reversal in the correlation between the number of COVID-19 cases and the dollar (from positive to negative). For most of the pandemic, investors have treated new waves of the pandemic as an indication that global growth will slow, which certainly occurred in the services sector this month. But the sheer speed at which the Omicron variant is spreading, in combination with the fact that it causes less severe disease than previous variants, has likely prompted some investors to expect that Omicron has shortened the amount of time to COVID-19 endemicity. An endemic disease, while still a public health issue, would imply less transmission and much less COVID-19-related hospitalization and death. Correspondingly, it would also likely be associated with a significant increase in services spending alongside stronger international travel, which would be positive for global growth (and thus negative for the dollar). Second, it is apparent that China-related assets have caught a bid, as illustrated by our market-based China growth indicator and its accompanying diffusion index (Chart I-16). While the indicators shown in Chart I-16 remain below the boom/bust line, they are rising quickly, and in a manner that suggests investors are reacting to new information. Chart I-15Portfolio Flows Have Likely Put Pressure On The Dollar Over The Past Few Months Chart I-16Since November, Optimism Towards China Has Also Likely Weakened The Dollar Chart I-17China Bulls Are Probably A Bit Too Early We doubt that investors would be upgrading their outlook for Chinese economic growth based on expectations of COVID-19 endemicity, given the country’s zero-tolerance COVID policy and the inability of the Sinovac vaccine to prevent transmission of Omicron. Therefore, we conclude that investors have become more optimistic about the pace of easing from Chinese policymakers, potentially sparked by a recent pickup in the pace of special purpose local government bond issuance (Chart I-17). We agree with investors that Chinese monetary policy is becoming easier at the margin. For example, the PBoC recently reduced its one-year loan prime rate (LPR) by 10 bps and five-year rate by 5 bps, following last week’s 10bps cut in the 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rate. This is on top of December’s 50 bps drop in the reserve requirement ratio (RRR). But we do not think that China’s credit data is yet heralding a meaningfully stronger growth impulse. Panel 2 of Chart I-17 presents the 12-month flow of China’s ex-equity total social financing as a share of nominal GDP, both including and excluding local government bond issuance. The chart highlights that the significant pickup in local government bond issuance has led to only a slight uptick in China’s overall credit impulse. Excluding local government bonds, China’s credit impulse continues to decline, reflecting an impaired monetary policy transmission mechanism and slowing bank loan growth. The implication is that it is too early to position aggressively towards China-sensitive commodities and global ex-US stocks, despite the recent pickup in our market-based growth indicator for China. At least some of the pickup in our market-based indicator reflects passive outperformance of some China-sensitive assets; Chart I-18 highlights that global ex-stocks and industrial metals prices have risen relative to US stock prices over the past month, but mostly because US stocks sold off in reaction to Fed hawkishness. Chart I-19 highlights that industrial metals prices continue to advance in a fashion that is not explained by the pace of China’s credit growth (as has generally been the case over the past decade), suggesting that metals are being somewhat supported by investment demand that is likely being driven by inflation hedging. We noted in our November Special Report that industrial commodities performed well during the stagflationary period of the 1970s,1 and over the past 40 years during months in which stock and bond returns are both negative. This makes metals an ideal portfolio hedge in the current environment, and we suspect that this factor – in addition to global inventory drawdowns last year – have kept prices elevated. Chart I-18Some Of The Rise In Our Market-Based China Growth Indicator Reflects Passive Outperformance Chart I-19Metals Prices Are Higher Than What Chinese Economic Growth Would Imply However, this also implies that metals prices could sell off at some point over the coming few months if US inflation fears begin to peak and Chinese monetary policy has not yet turned decisively reflationary. We are more comfortable with a bullish view toward industrial metals in the latter half of 2022, and recommend that investors buy metals on any dips in prices. Similarly, while we believe that investors should maintain global ex-US stocks on upgrade watch, we would prefer to see more evidence of a likely acceleration in Chinese economic activity before upgrading. In addition, we would also recommend that investors wait for the Ukrainian situation to play out, given the recent selloff in European stocks in response to the deepening crisis. A Likely War In Ukraine Last week, US President Joe Biden publicly predicted that Russia would likely invade parts of Ukraine, and implied that the sanction response from Western countries might be muted if the invasion were “minor”. Biden’s remarks have since been described as a gaffe, but in our view they were likely accurate. When combined with reports that the White House is warning domestic chipmakers of potential export restrictions to Russia in the event of an invasion, Biden’s remarks suggest that the US government does not believe that a diplomatic solution is likely and that Russia will probably send troops into Ukrainian territory. A full-scale invasion of Ukraine is very unlikely, as it would unite the Western world in delivering crippling economic sanctions towards Russia. The question for investors is whether the economic consequences of a minor incursion have significant enough implications to change one’s 12-month asset allocation stance. The extent of the rise in energy prices following a minor Russian incursion into Ukraine would be the key determinant of the impact that Russian military action would have on financial markets. Russia could withhold natural gas or oil exports to punish Europe if the Nord Stream II pipeline were cancelled. Oil prices would likely rise, even if retaliatory action was limited to the natural gas market, because oil consumption would rise as a substitute. This would further exacerbate the European energy crisis, although as we noted above, the PMI data continues to point to COVID as a more serious near-term threat to European economic activity than energy prices. Our geopolitical strategy team recently upgraded the odds of Russia invading Ukraine from 50% to 75%, suggesting that investors need to decide now whether to reduce risky asset exposure. The invasion has not yet occurred as we go to press, but could happen at any moment. All told, we doubt that a minor invasion will have a lasting, full-year impact on financial markets, but it is likely to have a near-term impact on the performance of some assets. While some of the risk of this event has already been priced in, on a 0-3 month time horizon, the US dollar would likely rally even further in response to an invasion and we suspect that the recent outperformance of global ex-US stocks would reverse (with the US outperforming). Our sense is that global equities may underperform government bonds for a short period following a minor incursion, but that a more aggressive Russian invasion would likely be needed to cause a persistent rise in the US dollar, US equity outperformance, and stocks to underperform bonds on a 12-month time horizon. Investment Conclusions Chart I-20We Expect Further Outperformance Of Value, Within The Context Of A Rising Stock-To-Bond Ratio Relative to the investment positions that we presented in our annual outlook report, we see no compelling reason to alter any of our recommendations on a 6-12 month time horizon. Over the nearer-term, a minor Russian incursion of Ukraine is now likely, and may further roil financial markets for a period of time. But the bar for the Ukrainian situation to durably impact returns on a 12-month time horizon is high, and implies a degree of conflict that we do not currently expect. US equities have sold off because of a rise in the discount rate and in the equity risk premium. We do not believe the latter is justified for the market as a whole. Our view that US equities have overreacted to the Fed’s hawkish shift and that long-maturity US bond yields have roughly another 50 basis points of upside this year strongly point to an overweight stance towards stocks versus bonds and a short-duration stance as still justified. We continue to expect that growth stocks will underperform value stocks over the coming year, but in the context of a rising rather than falling overall market (Chart I-20). It is too early to position aggressively toward China-sensitive commodities and global ex-US stocks, but investors should maintain these assets on upgrade watch. The US dollar may continue to reverse some of its recent decline over the coming 3 months in response to military conflict in Ukraine or if investors dial back their expectations for Chinese economic growth, but we expect a lower dollar in a year’s time. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2022 Next Report: February 24, 2022 II. The US Productivity Surge: Less Than Meets The Eye The current surge in US measured productivity looks very unlike what occurred in the mid-to-late 1990s. A detailed breakdown of labor productivity growth points to atypical labor market compositional effects – namely a significant decline in services employment – as being responsible for the apparent rise in productivity. In addition, technological disinflation, a major ingredient of the late 1990s “disinflationary boom”, is absent today. A cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the crisis. US output per worker surged compared to other countries, but the US fiscal response also generated a significant amount of excess income to support economic activity – unlike in the euro area, UK, and Japan. Micro-level arguments and some academic studies argue against the idea that work from home arrangements will ultimately be productivity-enhancing. Remote work makes it more difficult for firms to train the next generation of senior employees, which will raise the staffing risks for many businesses. While the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. If inflation remains significantly above target after the pandemic is over, the Fed’s long-term interest rate projections may rise. US stocks would suffer potentially large losses in a scenario where 10-year US Treasury yields rise towards the potential growth rate of the economy. Investors should consider reducing their equity exposure if 5-year, 5-year forward US Treasury yields break above 2.5%. We do not expect that to occur this year, which for now justifies an overweight stance towards risky assets. Chart II-1A Pandemic-Driven Productivity Surge? The behavior of US labor productivity during the COVID-19 pandemic has raised several questions among investors. As defined by output per hour worked, US productivity accelerated significantly over the first six quarters of the COVID-19 pandemic, but then fell sharply in Q3 2021 (Chart II-1). While some market participants have questioned the cause of the recent decline, investors have generally been more interested in the question of whether the US is in the middle of a long-lasting productivity surge that will help alleviate inflationary pressure – akin to what occurred in the second half of the 1990s. In this report, we review the recent surge in US labor productivity in contrast to what occurred in the late-1990s, and then compare it with what has occurred globally. While we are not pessimistic about the pace of technological advancement and its potential to drive long-run productivity, we conclude that the US is not likely experiencing a sustained productivity boom driven by technological adoption during the pandemic. This underscores why investors should not expect a significant increase in potential output owing to the pandemic or its effects. It also highlights that, if elevated inflation in response to strongly positive output gaps were to occur over the coming few years, it would likely be met by significantly tighter fiscal or monetary policy. Today Versus The 1990s: Total Factor Productivity Versus Capital Intensity Chart II-2The Technologically-Driven US Productivity Surge In The 1990s Was A Major Macro Event A technologically-driven surge in productivity growth in the second half of the 1990s was a highly significant macroeconomic event. Chart II-2 highlights that US labor productivity surged to over 3% from 1995 to 2000, alongside a significant deceleration in core PCE inflation and a sizeable acceleration in potential GDP growth. Given the acceleration in measured productivity during the pandemic, and the accompanying rapid adoption (or broader use) of technology, it is easy to see why some investors have questioned whether a 1990s-style productivity boom is underway. However, a detailed breakdown of the 2020 rise in labor productivity growth highlights substantial differences between the current environment and that of the late 1990s, which points instead to compositional effects as the main driver. Improvements in labor productivity can come from smarter workers, an increase in the amount of capital employed per worker, or from technological innovations and better working practices. The US Bureau of Labor Statistics provides a breakdown of the annual change in labor productivity that attempts to capture these three components: The contribution from shifts in labor composition: This measures the productivity impact of changes in the age, education, and gender structure of the labor force. The contribution from capital intensity: This measures the productivity impact of shifts in the amount of capital equipment available per worker. Total factor (or “multifactor”) productivity: This measures the changes in output per hour that cannot be accounted for by the above two factors. Thus, it includes the effects of technological changes, returns to scale, shifts in the allocation of resources, and other changes in operating procedures. Examining the 2020 rise in labor productivity growth along these three factors underscores key differences between the current environment and that of the late 1990s. The first point for investors to note is that the acceleration in labor productivity in 2020 occurred alongside a contraction in total factor productivity (TFP) growth, in contrast to the 1990s when TFP drove labor productivity (Chart II-3). The fact that TFP growth fell in 2020 means that the increase in labor productivity must have occurred either because of labor composition or capital intensity effects. In 2020, labor composition contributed somewhat to accelerating labor productivity, but that most of the increase was caused by a sharp increase in capital intensity. Some of the increase in overall capital intensity occurred because of an increase in the intensity of information processing equipment and intellectual property products (supporting the idea of an increase in pandemic-driven capital deployment), but this was outstripped by the contribution of “other” capital services (Chart II-4). Chart II-3Total Factor Productivity Collapsed In 2020, Unlike In The 1990s Chart II-4The Surge In US Capital Intensity Reflects A Rapid Compositional Shift In The Labor Market The concept of capital intensity refers to the amount of capital available per worker, but in practice it is measured as the ratio of the amount of capital used relative to the amount of labor hours used to produce output. Thus, a surge in capital intensity that is not accounted for by an increase in the amount of tech-related capital available to workers points to a rapid compositional shift in the economy from relatively low capital-intensive industries to relatively high-intensive industries. Under less extreme economic circumstances we would be more inclined to search for other potential causes of a rapid increase in measured capital intensity, but a shift in employment from less to more capital-intensive industries is exactly what has occurred during the pandemic. Services jobs tend to be much more labor-intensive than goods-producing jobs; Chart II-5 highlights that the former fell far more than the latter during the pandemic, in sharp contrast to what normally occurs during a recession (Chart II-6). This phenomenon is also reflected in a highly unusual decline in services spending compared with very strong goods spending relative to their pre-pandemic trend. Chart II-5Employment In Low Capital Intensity Services-Producing Industries Fell Far More Than Goods-Producing Chart II-6The Sharp Decline In Services Jobs During The Pandemic Was Unprecedented The takeaway for investors is that the nature of the pandemic and its unique impact on the economy has created the appearance of an acceleration in productivity, when in reality true productivity has fallen and the standard measure of productivity is being flattered by enormous changes in the composition of the labor market. Today Versus The 1990s: IT Investment, And Technological Disinflation The trends in IT investment and prices highlight another major difference between the current environment and that of the late 1990s. Charts II-7 and II-8 highlight recent trends in comparison to those of the 1990s, with the following notable points: Chart II-7There Are Major Differences Between IT Investment And Prices Today Versus The 1990s Chart II-8A One-Off Move The recent pace of real investment in total IT does not point to the pandemic as a sustained source of productivity growth. Real investment in IT has already slowed significantly, in contrast to the 1990s when it accelerated on a sustained basis for years. IT investment as a % of GDP and of total plant and equipment spending has already stopped rising (or is now falling), exhibiting clear signs of a one-off shift and thus undermining the view that IT investment has significantly raised potential output. In pronounced contrast to the mid-1990s when IT equipment prices were collapsing, computing equipment inflation has recently risen into positive territory – to the highest levels recorded since the data became available in 1959. Higher prices for IT equipment clearly reflect, at least in part, pandemic-driven pressure on global supply chains and the production of semiconductors. So we do not expect sustained increases in the price of computing equipment. But the key point for investors is that a major ingredient of the late 1990s “disinflationary boom” is missing today. The US Versus The World We have presented Chart II-9 in previous reports to highlight that there is certainly no evidence of a global productivity surge, using output per worker as a proxy for the standard measure of labor productivity (output per hour worked). Some investors have countered that the US is a more dynamic economy, and that a sustained productivity boom would be more apparent in the US prior to its emergence in other countries. Or simply that the US alone is experiencing a productivity boom that will help reduce very elevated US inflation, with strong implications for Fed policy. Chart II-9During The Pandemic, Cross-Country Changes In Real Output Per Worker… Chart II-10…Are Mostly Explained By Different Fiscal Responses Chart II-11High US Real Output Per Worker Also Reflects A Lagging Jobs Recovery Relative To Pre-Pandemic Levels Charts II-10 and II-11 present a different cross-country comparison that reinforces the view that the US is not likely experiencing a long-lasting productivity surge that will help reduce inflation. Chart II-10 highlights that in the face of a significant decline in employment, US output was supported by a substantial amount of “excess income” – the cumulative amount of household disposable income earned over the course of the pandemic in excess of what would have been predicted based on the pre-pandemic trend. Other major DM economies (such as the UK and euro area) either saw negative excess income or a modestly positive amount (Japan), underscoring that the fiscal response to the pandemic in most advanced economies was aimed at stabilizing income rather than raising it. In combination with Chart II-11 – which highlights that the US labor market recovery has significantly lagged behind the European and Canadian economies in terms of returning to the pre-pandemic employment trend – this would appear to explain why the US has experienced stronger real output per worker than other countries. Chart II-12Given A Similar Fiscal Response, Would The US Have Canada's Job Recovery If It Had Less COVID Cases? Canada stands out as the outlier compared with the US, in the sense that it’s growth in real output per worker has been much lower but Canadian fiscal policy created a similar amount of excess income. However, it may be the case that the Canadian experience highlights that the US labor market recovery is the outlier, which could imply that the surge in US labor productivity may in fact have inflationary rather than disinflationary consequences at the margin. We discussed the factors that we believe are driving the slow recovery in the US working-age population in our 2022 annual outlook report, and how they are strongly linked to the pandemic. However, Canada has also clearly been affected by COVID-19, and yet it has experienced a more significant recovery in jobs. Chart II-12 highlights that there has been one major difference between the US and Canada during the pandemic: a substantial gap in the burden of disease from COVID-19. This raises the question of whether Canada has outperformed the US in terms of its labor market recovery, despite a similarly impactful fiscal response, because of a smaller labor shortage stemming from long-term COVID symptoms. Over the past two years, there have been many reports about people who have recovered from COVID but who continue to experience some symptoms of the disease. The medical community has labeled this condition as post-acute sequelae of SARS-CoV-2 infection (PASC), colloquially referred to as “long COVID.” Chart II-13Long-COVID Might Help Explain The US’ Lagged Return To Pre-Pandemic Employment The medical community’s understanding of long COVID is currently poor, and doctors do not know why some people get the condition or what treatment options are likely to be the most effective. Given this, it is possible that some reports of long COVID are, in fact, related to other conditions. But a recent research report from Brookings estimated that the US labor market may be missing 1.6 million workers because of long COVID’s effects (Chart II-13), which alone would account for 1 percentage point (or roughly 1/4th) of the growth in US real output per worker since the pandemic began. This circumstance would be inflationary rather than disinflationary on the margin, as it would imply that accelerating first and second quartile US wage growth may be sticky even as the pandemic recedes. Is Working From Home Positive For Productivity? We have noted above that the macro data argues against the idea of a sustained rise in US productivity stemming from the pandemic. A more micro-level perspective, one that examines the working-from-home (WFH) experience, also appears to support our case. It is true that surveys of employees highlight that their experience of WFH has been significantly better on average than workers expected and report their being more productive while working from home during the pandemic. Chart II-14 emphasizes that, based on the running surveys from Barrero, Bloom, and Davis (“BBD”), 60% of workers have conveyed better WFH outcomes relative to expectations, versus just 14% reporting worse outcomes. In addition, Chart II-15 clearly highlights that workers prefer at least some form of hybrid WFH arrangement, with just 22% of survey respondents reporting the desire to work from home either rarely or never. Chart II-14Remote Workers Have Reported Better Work-From-Home Outcomes Than What Was Expected Chart II-15Remote Workers Clearly Prefer A Hybrid Work Model However, worker preferences do not necessarily correlate with productivity gains, at least not to the same degree. Chart II-16 from the BBD surveys highlights that the share of workers reporting more efficiency while working from home is not as large as those reporting better outcomes relative to expectations, suggesting that employees are considering whether WFH arrangements are benefiting them personally when responding to their desired post-pandemic level of remote work. Chart II-17 also shows that employees working from home only spend a third of the time ordinarily allocated to commuting to working on their primary job; the rest is spent on childcare, leisure, home improvement, or working on a second job (which may or may not be a sustainable source of income). Chart II-16Less Than Half Of Workers Report Being More Efficient While Working Remotely Chart II-17Only 1/3rd Of Time Saved Commuting Is Spent On Primary Employment There is also some evidence from academic studies that indicates productivity fell during the pandemic for some remote workers. Michael Gibbs, Friederike Mengel, and Christoph Siemroth (2021) surveyed 10,000 professionals at a large Asian IT services company, and found that productivity declined because of a slight decline in average output and a rise in hours worked.2 Admittedly, elements of the study did point to some factors potentially impacting this decline in productivity that were more prominent in the earlier phase of the pandemic, specifically the issue of childcare (which would not likely be a drag on remote worker productivity in a post-pandemic environment). But it also noted that employees with a longer company tenure fared better, which in our view is an often overlooked element of remote work that points to less future productivity gains from WFH arrangements than may be recognized by investors. The outperformance of senior staff in a WFH environment is not particularly surprising: once employees have accrued significant experience, they spend less of their working time learning and more (or all) of their working time “doing.” It makes sense that employees who predominantly “platform” their existing experience may fare the same or better in a WFH arrangement, but it is highly questionable whether it is sustainable, because it makes it much more difficult for businesses to train the next generation of senior employees. The Gibbs, Mengel, and Siemroth study noted that higher communication and coordination costs featured prominently in their findings of reduced remote worker productivity. Importantly, they found that employees communicated with fewer individuals and business units, both inside and outside the firm, and received less coaching and one-to-one meetings with supervisors. While some firms may be able to mitigate these risks to the advancement and development of more junior staff while maintaining a hybrid on-site / WFH model, we suspect that many firms will fail to do so fully. Future Productivity: Pessimism Unwarranted, But No Inflation Salvation The fact that the US is not likely in the middle of a pandemic-driven productivity boom does not mean that the outlook for productivity is poor. In fact, we would point to two factors that lead us to believe that productivity growth will be better in the future than it has been over the past decade: The pronounced consumer deleveraging phase that existed for several years following the global financial crisis is over, and There are several identifiable technologies currently under development that are likely to have legitimate commercial applications and productivity-enhancing benefits in the future On the first point, we have contended in previous reports that the weak productivity growth observed during the first half of the last economic expansion was because of demand rather than supply-side factors. This notion is jarring for many investors, who are accustomed to think of productivity trends as being exclusively driven by supply-side phenomena. This is typically correct, in that the cyclical impact of fluctuating aggregate demand on measured productivity – particularly during and immediately after recessions – is usually temporary in nature. However, the 2008/2009 recession was highly atypical, in the sense that it was a household “balance sheet” recession rather than a normal “income” recession. This led to a prolonged period of US household deleveraging, below-average corporate sales growth, and poor growth in output per hour worked. In effect, the post-2008 deleveraging phase created a long-lasting, multi-year cyclical effect on measured productivity growth. In early-2009, pessimistic investors held to an understandable reason for why they doubted the sustainability of the economic recovery: there could be no meaningful labor market recovery if businesses expected several years of weak demand because of the likelihood of consumer deleveraging. In this respect, the post-2008 period served as an important natural experiment for macroeconomists and investors: we have learned that the response of firms to a durable but shallow economic recovery is, on the one hand, to hire additional workers, but, on the other hand, also to control wage and salary costs aggressively. Chart II-18Slow Productivity Growth Last Cycle Was A Demand Story, Not A Supply Story Chart II-18 encapsulates the point that weak productivity during the last economic cycle was closely tied to US household deleveraging. The chart highlights that the decline in total factor productivity due to goods-producing industries – heavily concentrated in manufacturing – was much larger than for private services from 2007 to 2019. Since there was no technological slowdown that disproportionally impacted the manufacturing industry during the period, this clearly points to demand-side rather than supply-side factors as the main driver of the post-GFC productivity slowdown. On the second point about future productivity growth, Table II-1 outlines five well-known technologies that are in various stages of development and are likely to lead to significant applications at some point in the future: artificial intelligence, automated driving (a specific application of AI), quantum computing, augmented/virtual reality and human-machine interface, and CRISPR/gene editing. The table outlines the nature of potential future applications, as well as projections from McKinsey Global Institute about the most likely commercialization timeline. Table II-1Technological Advancement Is Ongoing. It Won’t Likely Help Fight Inflation Over The Next Few Years A detailed analysis of each of these technologies is beyond the scope of this report, but Table II-1 underscores two key points for investors. The first is that further, technologically-driven productivity growth is not just possible, it is likely. It is clear what advancements will probably drive these productivity gains, and Table II-1 highlights only the most well-known technologies to which experts in the field would point to. The second point is that most major changes from these technologies are projected to occur beyond 2025, and, in many cases, beyond this decade. In the case of quantum computing, while it could potentially lead to an explosion of algorithmic power that would almost certainly have major commercial implications, it is even possible that this technology will initially subtract from total factor productivity growth before contributing positively. This is because of its potential to render much of the existing global internet security and privacy infrastructure useless, as highlighted by a NIST Cybersecurity White Paper last April: “Continued progress in the development of quantum computing foreshadows a particularly disruptive cryptographic transition. All widely used public-key cryptographic algorithms are theoretically vulnerable to attacks based on Shor’s algorithm, but the algorithm depends upon operations that can only be achieved by a large-scale quantum computer. Practical quantum computing, when available to cyber adversaries, will break the security of nearly all modern public-key cryptographic systems.”3 Some experts believe that the preparation required to avoid this outcome may dwarf that of the millennium bug (“Y2K”) problem of the late-1990s,4 which cost roughly 1% of GDP to fix – and thus was clearly not productivity-enhancing. The bottom line for investors is that while the long-term outlook for technologically-driven productivity growth is bright, it is unlikely to save the US and/or global economies from elevated inflation over the next several years if output gaps in advanced economies rise to strongly positive levels in the wake of the pandemic. Investment Conclusions Our analysis above has highlighted that the current surge in measured productivity looks very unlike what occurred in the mid-to-late 1990s, and that very atypical labor market compositional effects are likely responsible for the apparent rise in labor productivity. We have also highlighted that a cross-country comparison of the growth in output per worker during the pandemic can be mostly explained by differences in the fiscal response to the pandemic, and that there are micro-level arguments against the idea that work from home arrangements are productivity-enhancing. Finally, while the long-term outlook for technologically-driven productivity growth is positive, projected commercialization timelines for several well-known technologies under development do not point to an imminent, inflation-offsetting boom in potential output. While we believe that the COVID-19 pandemic will recede in importance this year, it is not yet over. As such, investors do not yet know how strong the output gap in the US and other advanced economies will be on average over the coming two to three years, or what the pace of consumer price inflation will look like in the face of strong aggregate demand but substantially lower (or no) pressure from the supply-side of the economy (as we expect). Chart II-19There Is A Lot Of Downside For Stocks If Bond Yields Rise To Potential Growth Rates In a scenario in which aggregate demand remains strong next year and inflation remains above-target, even in the face of Fed tightening and a normalization in services/goods spending, we would expect to see significantly tighter fiscal or monetary policy. This is a scenario in which the secular stagnation narrative, which underpins the Fed’s low long-term interest rate projection, would likely be aggressively challenged by investors. Chart II-19 highlights that US equities would potentially suffer a 24% contraction in the forward P/E in a scenario in which the equity risk premium is in line with its historical average and 10-year US Treasury yields rise to the potential growth rate of the economy. We do not yet believe that a significant rise in long-term interest rate expectations will occur this year, meaning that investors should still be overweight stocks versus government bonds over the coming 6-12 months. But as we noted in last month’s report, we may recommend that investors reduce their equity exposure if 5-year, 5-year forward Treasury yields break above 2.5% (the FOMC’s long-run Fed funds rate projection), which we noted in Section 1 of our report is 50 basis points above current levels. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Content Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2     Michael Gibbs, Friederike Mengel, and Christoph Siemroth. “Work from Home & Productivity: Evidence from Personnel & Analytics Data.” Working Paper No. 2021-56. July 13, 2021. Pp. 1-30. 3    William Barker, William Polk, and Murugiah Souppaya. “Getting Ready for Post-Quantum Cryptography: Exploring Challenges Associated with Adopting and Using Post-Quantum Cryptographic Algorithms.” National Institute of Standards and Technology, US Department of Commerce. April 28, 2021. Pp. 1-7. 4    Jonathan Ruane, Andrew McAfee, and William Oliver. “Quantum Computing for Business Leaders.” Harvard Business Review, January-February 2022.

Highlights US Vs. Europe: Growth and inflation momentum remains stronger in the US versus Europe. The latter is taking the bigger economic hit from more severe Omicron economic restrictions and a greater exposure to slowing Chinese demand. European inflation has accelerated, but remains slower and less broad-based than elevated US inflation. The backdrop remains more negative for US fixed income compared to Europe. UST-Bund Spread: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures). Feature Chart of the WeekUS Bond Yields & Bond Volatility Are Both Rising Global fixed income markets are off to a volatile start in 2022, on the back of significant repricing of US interest rate expectations. The 10-year US Treasury yield now sits at 1.85%, up +34bps so far in January and is up +72bps from the August 4/2021 intraday low of 1.13%. The 2-year US yield, which is even more sensitive to changes in Fed expectations, is 1.04%, up +31bps so far this month and up +87bps since early August 2021. Yields are rising in other countries as well, with the 10-year benchmark government bond yield up year-to-date in the UK (+24bps), Canada (+45bps) and even Germany (+18bps) where the Bund yield is threatening to return to positive territory. US Treasuries are selling off as markets have heeded the hawkish shift in the Fed’s interest rate guidance. The US overnight index swap (OIS) curve now discounting 89bps of Fed rate hikes in 2022. Bond volatility further out the Treasury curve has increased as yields have moved higher, with the realized volatility of the Bloomberg 7-10 US Treasury index now at an 19-month high (Chart of the Week). We continue to recommend a defensive strategic posture towards direct US Treasuries with below-benchmark exposure on both duration and country allocations in global bond portfolios. However, we prefer a more efficient way to position for the same theme of rising US yields – betting on a wider 10-year US Treasury-German Bund spread. US Growth & Inflation Fundamentals Support A More Hawkish Fed The rise in global bond yields seen in recent weeks has inflicted damage on risk assets, but not in a consistent fashion. Equity markets have taken the brunt of the hit, with the S&P 500 down around -3% so far in January with the tech-heavy NASDAQ down -6%. Yet the MSCI emerging market equity index is up around +1%, European equities are flat and global high-yield corporate bond spreads are essentially unchanged so far this month. While higher bond yields are reflecting expectations of more global monetary tightening over the next year, medium-term interest rate expectations remain subdued. Our proxy for the market pricing of terminal interest rate expectations – 5-year OIS rates, 5-years forward – remains at or below pre-pandemic levels in the US, the UK, Canada and the euro area (Chart 2). Risk assets are performing relatively well in the face of higher bond yields because markets still do not believe that a major increase in interest rates will be needed in the current global tightening cycle. We see this – the likelihood that interest rates will have to rise much more than markets expect - as the biggest vulnerability for global bond markets over the next couple of years. The US remains the “poster child” for this view. In the US, core CPI inflation accelerated to an 31-year high of 5.5% in December. The pickup in US inflation continues to be broad-based, with the Cleveland Fed median CPI and trimmed mean CPI inflation measures reaching 3.8% and 4.8%, respectively (Chart 3). This massive run-up in US inflation has filtered through to medium-term household inflation expectations; the preliminary University of Michigan consumer survey for January showed that inflation 5-10 years out is expected to be 3.1% - the highest level in 13 years. Chart 2Rising Yields Are Not A Threat To Risk Assets ... Yet​​​​​ Chart 3The Fed Cannot Ignore Elevated Inflation Expectations​​​​​​ Chart 4US Demand Steadily Normalizing From The Pandemic Shock While much of the run-up in US inflation over the past year has been fueled by supply chain disruption and high energy prices, there is still a robust demand component to the high inflation. Consumer spending on goods remains elevated versus its pre-pandemic trend, while services spending is steadily returning back to the pre-pandemic pace (Chart 4). The overall US unemployment rate is now down to 3.9%, the lowest level since February 2020, with broad-based strength in the US labor market across most industries (bottom panel). The rise in consumer inflation expectations has to be most worrisome to Fed officials. Yes, market-based inflation expectations have already seen a significant run-up since the mid-2020 lows, and have even drifted down a bit of late on the back of the more hawkish rhetoric from the Fed. However, survey-based measures of inflation expectations tend to be less volatile than market-based measures, and typically follow trends in realized inflation, which is not slowing down in the US. In other words, rising household inflation expectations are a more reliable indication that an inflationary mindset is becoming entrenched in consumer behavior. US inflation dynamics are transitioning away from supply-driven goods inflation toward more lasting domestically driven forces like tight labor markets, faster wage growth and rising housing costs (Chart 5). Measures of supply chain disruption like global shipping costs are showing signs of peaking (top panel), while commodity price momentum has clearly rolled over – both should eventually feed into slower goods inflation this year. At the same time, tight labor markets will continue to boost US employment costs, which historically have been strongly correlated to US services inflation (middle panel). Chart 5US Inflation Pressures Remain Intense Meanwhile, shelter costs, which represents 32% of the US CPI index, were up 4.2% on a year-over-year basis in December and are likely to continue accelerating given a dearth of housing supply versus demand that is pushing up both house prices and rents (bottom panel). Tying it all together, there are good reasons why the Fed has ramped up the hawkish rhetoric over the past couple of months. However, with the US OIS curve now discounting between 3-4 rate hikes in 2022, it will be harder to generate a second consecutive year of negative returns in the US Treasury market this year. Dating back to the early 1970s, there have only been five calendar years where the Bloomberg US Treasury index delivered an outright negative total return: 1994, 1999, 2009, 2013 and 2021 (Chart 6). None of the four cases prior to last year saw negative returns in the following year, as Treasury yields fell in 1995, 2000, 2010, 2014. Yet even the episodes that saw consecutive years of US yield increases – 1974-75, 1977-81, 1987-88, 2005-06 and 2015-16 – did not see outright negative returns from the Bloomberg US Treasury index. Chart 6Negative Return Years For US Treasuries Are Rare Given the starting point of deeply negative real US bond yields, and interest rate expectations that remain too low beyond 2022, we still see value in staying below-benchmark on US duration exposure on a medium-term basis. However, we see a more efficient way to play for higher Treasury yields this year by positioning US Treasury underweights/shorts versus overweights/longs in government bonds in a region where discounted rate hikes will not happen – Europe. The ECB Is In No Hurry To Hike Rates The same supply driven factors that have pushed up US inflation over the past year have also lifted inflation in the euro area. Headline HICP inflation reached an 30-year high of 5.0% in December, while core HICP inflation hit an all-time high of 2.6%. The European Central Bank (ECB), however, is unlikely to deliver any rate hikes in 2022 even with the high inflation, for several reasons (Chart 7): Growth momentum entering 2022 was soft, thanks to Omicron related economic restrictions at the end of 2021 and also weak demand for European exports from China. It will take time for both of those factors to reverse, thus reducing any growth related pressure to tighten monetary policy. Inflation expectations are not exceeding the ECB 2% inflation target, with the 5-year/5-year forward EUR CPI swap now at 1.9% even with headline inflation of 5.0%. The surge in European energy prices will eventually subside in the first half of 2022, which will reduce inflationary pressure on the ECB to tighten. The ECB is ending its pandemic emergency bond buying program (PEPP) in March, and is only partially replacing that buying activity by upsizing its existing pre-pandemic asset purchase program (APP). The ECB will not want to compound the effect of this “tapering” of bond buying by also hiking interest rates, which would surely tighten financial conditions further through higher Italian government bond yields, rising corporate bond yields and a firmer euro. There is little evidence to date showing any pass-through of higher energy-fueled inflation into more domestically-driven inflation. Euro area wage growth was only 1.3% as of the latest available data in Q3/2021 (which is still well after realized inflation had started to accelerate), highlighting the lack of visible “second round” effects on euro area inflation from high energy prices that would prompt the ECB to consider rate hikes (Chart 8). Chart 7An ECB Rate Hike In 2022 Is Unlikely​​​​​​ Chart 8Limited 'Second Round' Effects From Energy-Driven European Inflation​​​​​​ The EUR OIS curve is discounting 7bps of rate hikes by year-end. Even that modest amount will not be delivered, which will limit how much further European government bond yields will rise this year. A Better Mousetrap: Playing UST Bearishness Through UST-Bund Spread Widening Trades Combining our view of an increasingly hawkish Fed and a still-dovish ECB produces our highest conviction investment recommendation for 2022: positioning for a wider 10-year US Treasury/Germany Bund spread. This can be done by underweighting the US versus core Europe in global bond portfolios, or shorting US Treasury futures versus German Bund futures as we are already recommending in our Tactical Trade Overlay (see page 15). A Treasury-Bund spread widening view is a more efficient way to play for a more hawkish Fed and higher US Treasury yields, for several reasons: There are many examples over past 30 years where the Treasury-Bund spread widened in consecutive years (Chart 9). This is in contrast to the fewer occurrences of consecutive years of rising Treasury yields shown earlier in this report. Thus, there are better odds that last year’s Treasury-Bund spread widening can be repeated in 2022. Chart 9Consecutive Years Of A Rising UST-Bund Spread Happen Often The realized volatility of Treasury-Bund spread trades is almost always lower than that of an outright short position in US Treasuries, but the direction of returns of the two trades is similar (Chart 10). This shows that there is directionality in the Treasury-Bund spread (i.e. it is driven far more by the movements of US yields), but that is a welcome feature given our more bearish view on US Treasuries. The Treasury-Bund spread remains well below fair value on our fundamental valuation model, with fair value increasing due to widening US-European inflation differentials (Chart 11). Tighter relative monetary policies this year (more tapering and rate hikes from the Fed compared to the ECB) also favor a wider fair value spread on our model. Chart 10UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts​​​​​ Chart 11The UST-Bund Spread Looks Very Cheap On Our Model​​​​​​ The gap between our 24-month discounters, which measure the change in policy interest rates over the next two years discounted in OIS curves, for the US and euro area is a reliable leading indicator of the 10-year Treasury-Bund spread (Chart 12, bottom panel). The “discounter spread” is currently calling for the Treasury-Bund spread to widen by more than the current path discounted in US Treasury and German Bund forward rates. Chart 12Position For More UST-Bund Spread Widening In 2022​​​​​​ Chart 13UST-Bund Spread Is Not Technically Stretched​​​​​ The Treasury-Bund spread is not stretched from a technical perspective (Chart 13). The spread is sitting right at its 200-day moving average and the 26-week change in the spread (a measure of price momentum) is rising but remains well below previous peak levels that have capped past spread increases. Summing it all up, the case is strong for including US-Germany spread widening positions as core holdings in investor portfolios in 2022. The current spread is 185bps and we have a year-end target of 225bps. Bottom Line: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary   Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The neutral rate of interest in the US is 3%-to-4% in nominal terms or 1%-to-2% in real terms, which is substantially higher than the Fed believes and the market is discounting. The end of the household deleveraging cycle, rising wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand. In addition, deglobalization and population aging are depleting global savings, raising the neutral rate in the process. A higher neutral rate implies that monetary policy is currently more stimulative than widely perceived. This is good news for stocks, as it reduces the near-term odds of a recession. The longer-term risk is that monetary policy will stay too loose for too long, causing the US economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Investors should overweight stocks in 2022 but look to turn more defensive in late 2023. We are taking partial profits on our long December-2022 Brent futures trade, which is up 17.3% since inception. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it.  The Neutral Rate Matters At first glance, the neutral rate of interest – the interest rate consistent with full employment and stable inflation – seems like a concept only an egghead economist would care about. After all, unlike actual interest rates, the neutral rate cannot be observed in real time. The best one can do is deduce it after the fact, something that does not seem very relevant for investment decisions. While this perspective is understandable, it is misguided. The yield on a long-term bond is largely a function of what investors expect short-term rates to be over the life of the bond. Today, investors expect the Fed to raise rates to only 1.75% during this tightening cycle, a far cry from previous peaks in interest rates (Chart 1). Chart 2Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Chart 1Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates     Far from worrying that the Fed will keep rates too low for too long in the face of high inflation, investors are worried that the Fed will tighten too much. This is the main reason why the yield curve has flattened over the past three months and the 20-year/30-year portion of the yield curve has inverted (Chart 2). Secular Stagnation Remains The Consensus View Why are so many investors convinced that the Fed will be unable to raise rates all that much over the next few years? The answer is that most investors have bought into the secular stagnation thesis, which posits that the neutral rate of interest has fallen dramatically over time. The secular stagnation thesis comes in two versions: The first or “strong form” describes an economy that needs a deeply negative – and hence unattainable – nominal interest rate to reach full employment. Japan comes to mind as an example. The country has had near-zero interest rates since the mid-1990s; and yet it continues to suffer from deflation. The second or "weak form" describes the case where a country needs a low, but still positive, interest rate to reach full employment. Such an interest rate is attainable by the central bank, and hence creates a goldilocks outlook for investors where profits return to normal, but asset prices continue to get propped up by an ultra-low discount rate. The “weak form” version of the secular stagnation thesis arguably describes the United States. Post-GFC Deleveraging Pushed Down The Neutral Rate One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If something causes the aggregate demand curve to shift inwards, a lower real interest rate would be required to bring demand back up (Chart 3). Like many other countries, the US experienced a prolonged deleveraging cycle following the Global Financial Crisis. The ratio of household debt-to-GDP has declined by 23 percentage points since 2008. The need for households to repair their balance sheets weighed on spending, thus necessitating a lower interest rate. Admittedly, corporate debt has risen over the past decade, with the result that overall private debt has remained broadly stable as a share of GDP (Chart 4). However, the drag on aggregate demand from declining household debt was not offset by the boost to demand from rising corporate debt. Whereas falling household debt curbed consumer spending, rising corporate debt did little to boost investment spending. This is because most of the additional corporate debt went into financial engineering – including share buybacks and M&A activity – rather than capex. In fact, the average age of the private-sector capital stock has increased from 21 years in 2010 to 23.4 years at present (Chart 5). Chart 4Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Chart 5The Average Age Of Capital Stock Has Been Increasing Buoyant Consumer And Business Spending Will Prop Up The Neutral Rate Today, the US economy finds itself in a far different spot than 12 years ago. Households are borrowing again. Consumer credit rose by $40 billion in November, the largest monthly increase on record, and double the consensus estimate (Chart 6). Banks are easing lending standards across all consumer loan categories (Chart 7). Chart 6Big Jump In Consumer Credit Chart 7Banks Are Easing Lending Standards For All Consumer Loans Chart 8Net Worth Has Soared Over The Past Two Years Meanwhile, years of easy money have pushed up asset prices, a dynamic that was only supercharged by the pandemic. We estimate that household wealth rose by 145% of GDP between the end of 2019 and the end of 2021 – the largest two-year increase on record (Chart 8). A back-of-the-envelope calculation suggests that this increase in wealth could boost aggregate demand by 5%.1 Reacting to the prospect of stronger final demand, businesses are ramping up capex (Chart 9). After moving sideways for two decades, capital goods orders have soared. Surveys of capex intentions remain at elevated levels. Against the backdrop of empty shelves and warehouses, inventory investment should also remain robust. Residential investment will increase (Chart 10). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 10-month high in December. Building permits are 11% above pre-pandemic levels. Amazingly, homebuilders are trading at only 7-times forward earnings. We recommend owning the sector. Chart 9Investment Spending Will Stay Strong Chart 10US Housing Will Remain Well Supported Fiscal Policy: Tighter But Not Tight Chart 11Chinese Credit Impulse Seems To Be Bottoming As in most other countries, the US budget deficit will decline over the next few years, as pandemic-related measures roll off and tax receipts increase on the back of a strengthening economy. Nevertheless, we expect the structural budget deficit to remain 1%-to-2% of GDP larger in the post-pandemic period, following the passage of the infrastructure bill last November and what is likely to be a slimmed down social spending package focusing on green energy, universal pre-kindergarten, and health insurance subsidies. The shift towards structurally more accommodative fiscal policies will play out in most other major economies. In the euro area, spending under the Next Generation EU recovery fund will accelerate later this year, with southern Europe being the primary beneficiary. In Japan, the government has approved a US$315 billion supplementary budget. Matt Gertken, BCA’s Chief Geopolitical Strategist, expects Prime Minister Kishida to pursue a quasi-populist agenda ahead of the upper house election on July 25th.  China is also set to loosen policy. The Ministry of Finance has indicated that it intends to “proactively” support growth in 2022. For its part, the PBoC cut the reserve requirement ratio by 50 basis points on December 6th. The 6-month credit impulse has already turned up (Chart 11). More Than The Sum Of Their Parts Chart 12The Labor Share Typically Rises When Unemployment Falls As discussed above, the end of the deleveraging cycle, rising household wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand in the US. While each of these factors have independently raised the neutral rate of interest, taken together, the impact has been even greater. For example, stronger consumption has undoubtedly incentivized greater investment by firms eager to expand capacity. Strong GDP growth, in turn, has pushed up asset prices, leading to even more spending. Furthermore, a tighter labor market has propped up wage growth, especially among low-wage workers. Historically, labor’s share of overall national income has increased when unemployment has fallen (Chart 12). To the extent that workers spend more of their income than capital owners, a higher labor share raises aggregate demand, thus putting upward pressure on the neutral rate. The Retreat From Globalization Will Push Up The Neutral Rate… Chart 13The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade Globalization lowered the neutral rate of interest both because it shifted the balance of power from workers to businesses; and also because it allowed countries such as the US, which run chronic current account deficits, to import foreign capital rather than relying exclusively on domestic savings.  The era of hyperglobalization has ended, however. The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 13). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. … As Will Population Aging Chart 14Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Aging populations can affect the neutral rate either by dragging down investment demand or by reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 14 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades. In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 15). As baby boomers transition from net savers to net dissavers, national savings will fall, leading to a higher neutral rate. The pandemic has accelerated this trend insomuch as it has caused about 1.2 million workers to retire earlier than they would have otherwise (Chart 16). Chart 16Number Of Retired People Jumped During The Pandemic To What Extent Are Higher Rates Self-Limiting? Some commentators contend that any effort by central banks to bring policy rates towards neutral would reduce aggregate demand by so much that it would undermine the rationale for why the neutral rate had increased in the first place. In particular, they argue that higher rates would drag down asset prices, thus curbing the magnitude of the wealth effect. While there is some truth to this argument, its proponents overstate their case. History suggests that stocks tend to brush off rising bond yields, provided that yields do not rise to prohibitively high levels (Table 1). Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Chart 17The Equity Risk Premium Remains High The last five weeks are a case in point. Both 10-year and 30-year Treasury yields have risen nearly 40 bps since December 3rd. Yet, the S&P 500 has gained 2.7% since then. Keep in mind that the forward earnings yield for US stocks still exceeds the real bond yield by 552 bps, which is quite high by historic standards. The gap between earnings yields and real bond yields is even greater abroad (Chart 17). Thus, stocks have scope to absorb an increase in bond yields without a significant PE multiple contraction. Investment Implications Our analysis suggests that the neutral rate of interest in the US is substantially higher than widely believed. How much higher is difficult to gauge, but our guess is that in real terms, it is between 1% and 2%. This is substantially higher than survey measures of the neutral rate, which peg it at close to 0% in real terms (Chart 18). It is also significantly higher than 10-year and 30-year TIPS yields, which stand at -0.73% and -0.17%, respectively (Chart 19). The neutral rate has also increased in other economies, although not as much as in the US. Chart 18Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Chart 19Long-Term Real Rates Remain Depressed If the neutral rate turns out to be higher than the consensus view, then monetary policy is currently more stimulative than widely perceived. That is good news for stocks, as it would reduce the near-term odds of a recession. Hence, we remain positive on stocks over a 12-month horizon, with a preference for non-US equities. In terms of sector preferences, we maintain our bias for banks over tech. The longer-term risk is that monetary policy will stay too easy, causing the economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Such a day of reckoning could be reached by late 2023. Two Trade Updates We are taking partial profits on our long December-2022 Brent futures trade by cutting our position by 50%. The trade is up 17.3% since inception. Bob Ryan, BCA’s Chief Commodity Strategist, still sees upside for oil prices, so we are keeping the other half of our position for the time being. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it. While the outlook for both companies remains challenging, there is an outside chance that they will find a way to leverage their meme status to create profitable businesses. This makes us inclined to move to the sidelines.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 In line with published estimates, we assume that households spend 5 cents of every one dollar increase in housing wealth, 2 cents of every dollar increase in equity wealth, 10 cents out of bank deposits, and 2 cents out of other assets. Of the 145% of GDP in increased household net worth between the end of 2019 and the end of 2021, 19% stemmed from higher housing wealth, 52% from higher equity wealth, 12% from higher bank deposits, and 17% from other categories.    View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Data from the UK revealed it is tantalizingly close to declaring COVID-19 an endemic virus, indicating Britain likely will exit the pandemic ahead of other states soon. The UK is a bellwether market regarding its public-health response to the coronavirus. Some 95% of its population is estimated to carry COVID-19 antibodies (Chart of the Week). Other states – e.g., the US, the EU – have followed the UK with a lag, which we expect will continue. While the Fed's reassurance it will be able to hike rates without disrupting labor markets no doubt encourages markets – and boosted commodity prices – we believe the return to economic normalcy that would be ushed in by endemicity will release pent-up consumer demand for goods and services. This will spur commodity demand. If COVID-19 becomes endemic in enough economies globally, it also would fuel inflation, and inflation expectations.1 Given the tight supplies of industrial commodities – chiefly oil, natural gas and base metals – our assessment of upside price risk is higher now than it was at year-end 2021. We remain long broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Feature Fed Chair Powell's confidence that the US central bank will raise rates and keep inflation under control without destabilizing labor markets stole the show earlier this week. The media credited Powell's remarks for the burst of enthusiasm that lifted commodities as an asset class higher. While none would gainsay the Fed's importance to commodity markets, we would point out the approaching endemicity of COVID-19 in the UK – and the likely follow-on from the US and other large commodity-consuming states – is of equal, if not greater, moment. The UK has been out in front on its public-health response to the COVID-19 pandemic and has become a bellwether in the northern hemisphere; the US will follow. This week, the UK's Office for National Statistics (ONS) reported ~ 95% of England's population tested positive for antibodies to COVID-19 via infection or vaccination in the week beginning 29 November 2021. Similar results were reported for Scotland, Wales and Northern Ireland. This is generally observed in all age cohorts tracked by ONS.2 According to David Heymann of the London School of Hygiene and Tropical Medicine, "population immunity seems to be keeping the virus and its variants at bay, not causing serious illness or death in countries where population immunity is high."3 In a briefing hosted by Chatham House this week, Heymann observed, “And probably, in the UK, it’s the closest to any country of being out of the pandemic if it isn’t already out of the pandemic and having the disease as endemic as the other four coronaviruses” currently in circulation, which are responsible for roughly a quarter of common colds.4 Based on UK government data, the ratios of hospitalizations and deaths to COVID-19 cases has been falling precipitously (Chart 2). This is encouraging, given the sharp increase in cases driven by the rapid spread of the omicron mutant, which appears to be rolling over. Medical experts in the UK suggest the data also point to a possible peaking in the omicron surge. This would lighten the load on hospitals, as well as reduce death rates attributed to the coronavirus (Chart 3).5 Return To Normal? Nothing will return commodity markets to economic normalcy faster than endemicity. If this stays on track over the next month or so, it will spur commodity demand sooner rather than later, as pent-up consumer demand for goods and services is discounted by trading markets. If, as the data appear to indicate, the UK's transition from pandemic to endemic COVID-19 is followed by other states like the US and EU a few months later, we would expect a renewed leg up in the post-pandemic commodities rally. This would be apparent in futures contracts, which already are pricing commodity deliveries a month or more hence. Such a turn of events would force us to accelerate our time table for oil-demand recovery, which we expect will come in 2H22. This could restore our $80/bbl forecast for 2022, and lift our 2023 expectation. We also would have to revisit our copper and base metals view, and bring forward the timing of the copper-price rally we expect will lift COMEX refined copper to $4.80/lb and $6.00/bbl in 2022 and 2023, respectively, on average.6 These industrial commodities would see demand increase amid extremely tight supply conditions. Oil markets are tightening on the back of OPEC 2.0's production discipline, and the inability of many member states to fully restore the 400k b/d every month it signed on for beginning in August of last year, owning to production shortfalls outside the core producers of the coalition (Chart 4). Copper, the base-metals bellwether, remains very tight, as seen in balances (Chart 5) and inventories (Chart 6). Chart 4OPEC 2.0s Strategy Works Chart 5Coppers Physical Deficits Will Persist... Chart 6Globally, Exchange Warehouses Tighten China's zero-COVID-19 policy, which has resulted in numerous lock-downs at the local level, has yet to dent oil demand, which, for the time being, is hovering ~ 16mm b/d. We will be updating our oil balances and price forecasts next week, and will have a more extensive analysis of supply-demand balances then. Return Of Speculative Interest Expected With Endemicity Hedge funds have been reducing their exposure to the industrial commodities over the past year, which suggests they either have better alternatives for investing, or did not believe the rallies in commodities over the past year were durable, given the repeated demand shocks visited upon these markets by COVID-19 (Chart 7). We expect that once the pandemic becomes endemic, hedge funds will return to these markets. All the same, given the higher likelihood of price rallies in these markets, we would expect hedge funds to be cited as a cause of higher prices, as typically happens when markets take a sharp leg higher. Regular readers of our research are aware that this generally is not the case – hedge funds follow the news; they don't lead it. This past week we revisited earlier research to see if hedge-fund involvement in commodity markets causes the prices to go up or down to any meaningful degree. And, again, we found no relationship between hedge-fund positioning and the level of commodity prices.7 The presumed influence of hedge funds has been a persistent feature of futures markets in the post-GFC world, following the collapse of commodity prices along with financial markets in 2008. An entire literature has sprung up to explore the influence of these funds on commodity price formation. Below we highlight a few representative articles consistent with our results. Büyüksahin and Harris (2011) show hedge funds and other speculators follow prices – they do not lead them – based on the Granger-causality testing they performed on oil prices and speculative positioning.8 Brunetti et al (2016) argue hedge funds' trading stabilizes markets – i.e., they provide a bid when markets are selling off and an offer when markets are well bid – while swap-dealer trading is uncorrelated with price volatility.9 Knittel and Pindyck (2016) found speculation has reduced volatility in prices since 2004, including during the 2007-08 price run-up.10 Using a straightforward supply-demand-inventory model, they examined cash and storage markets to determine whether speculation had any effect on them or on convenience yields based on cash-vs-futures spreads. They concluded: "We found that although we cannot rule out that speculation had any effect on oil prices, we can indeed rule out speculation as an explanation for the sharp changes in prices beginning in 2004. Unless one believes that the price elasticities of both oil supply and demand are close to zero, the behavior of inventories and futures-spot spreads are simply inconsistent with the view that speculation has been a significant driver of spot prices. If anything, speculation had a slight stabilizing effect on prices." Investment Implications Assuming the UK remains a bellwether for DM economies with reasonably effective vaccine programs, or which have experienced an omicron surge, markets could be close to exiting the COVID-19 pandemic and entering a phase in which the coronavirus is endemic. This would be bullish for demand. And given the extended tightness on the supply side for industrial commodities in particular, it could presage another leg up in prices as economic normalcy returns. We continue to favor broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index.   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 US LNG baseload and peak liquification capacity is expected to rise ~ 13% this year to 11.4 Bcf/d and 13.8 Bcf/d (on a December-to-December basis), based on the EIA's latest estimates. The agency's forecast for LNG exports is up 17.3% to 11.5 Bcf/d this year, and 12.1 Bcf/d in 2023. With these increases in baseload and peak export capacity, the US is set to become the largest exporter of LNG in the world this year, in the EIA's estimation. This will be integral to US foreign policy, particularly in markets where the US competes with Russia for export sales, in our estimation. Within North America, US pipeline gas exports to Mexico and Canada are expected to average just under 9 Bcf/d this year, a 5% increase vs. 2021, and 9.2 Bcf/d in 2023. Base Metals: Bullish In China, seasonally low production, as stainless-steel firms undergo maintenance, and the upcoming Winter Olympics in February are keeping steel production subdued. To compound this supply shortage, tight raw material markets, particularly that of iron ore and nickel are buoying steel prices. Heavy rainfall in southern-eastern Brazil is curtailing iron ore production in the region. After Australia, Brazil is the second largest iron ore exporter to China. Nickel prices hit a 10-year high on Tuesday on the back of falling inventories. An LME outage also precipitated the price rise. Dwindling inventories point to increasing demand for the metal as electric vehicle companies ramp-up production and sales this year, particularly in China, where the government stated it will remove EV subsidies by the end of 2022. According to The China Passenger Car Association, EV sales in the country will double to 6 million this year. Precious Metals: Bullish Based on the December FOMC minutes, the markets are now pricing in a more hawkish tilt from the Fed, and expect an initial rate hike by March. The Fed may also shrink its balance sheet soon after the initial rate hike, in line with its expectation the U.S. economy will recover faster this time around. While higher nominal interest rates and tighter monetary policy will increase the opportunity cost of holding gold (Chart 8), the commodity-driven inflation we expect this year – especially if COVID-19 becomes endemic across major economies – will buoy demand for the yellow metal as an inflation hedge. An endemic virus this year will also boost physical gold demand from China and India.       Footnotes 1     Please see More Commodity-Led Inflation On The Way, which we published on 9 December 2021. 2     Please see Coronavirus (COVID-19) latest insights: Antibodies, published by the ONS on December 23, 2021. 3    Please see Covid-19: UK ‘closest of any country in northern hemisphere to exiting pandemic’, published on January 11, 2022 by msn.com. 4    Please see What four coronaviruses from history can tell us about covid-19, published by newscientist.com on April 29, 2020. 5    Please see Omicron may be headed for a rapid drop in US and Britain, published by msn.com on January 11, 2022 published by msn.com. 6    Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. 7     We ran cointegrating regressions – using DOLS and ARDL models – to check for any equilibrium between prices and hedge fund positioning and found none. We looked at the post-GFC period from 2010 to now, since this is the data the US Commodity Futures Trading Commission (CFTC) provides for hedge funds and tested whether hedge-fund positions (in the form of open interest) explained prices vs. the alternative (i.e., prices explain hedge-fund positioning). We again found prices explain position (and not vice versa) for crude oil, natural gas, copper and gold. 8    Please see Büyüksahin, Bahattin and Jeffrey H. Harris (2011),"Do Speculators Drive Crude Oil Futures Prices?" The Energy Journal, 32:2, pp. 167-202. This paper used unique data sets provided by the CFTC. 9    Please see Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), "Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74. 10   Please see Knittel, Christopher R. and Robert S. Pindyck (2016), "The Simple Economics of Commodity Price Speculation," American Economic Journal: Macroeconomics 8:2, pp. 85–110. Investment Views and Themes Strategic Recommendations Trades Closed In 2021