Global

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 9The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights There is a high risk of a global demand shortfall in 2022. This is because consumer demand for services will remain well below its pre-pandemic trend… …while the recent booming demand for goods is crashing back to earth. Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Fractal analysis: Overweight gas distribution. Feature Chart of the WeekSpending On Services In The US Is Still Far Below The Pre-Pandemic Trend. Will It Catch Up In 2022? With inflation surging, you would be forgiven for thinking that global demand is red-hot. Sadly, global demand is not red-hot. Two years after the pandemic began, the lynchpin of demand – consumer spending on services – remains far below its pre-pandemic trend. For example, US consumer spending on services is around $420 billion, or 5 percent, below where it should be (Chart I-1). A similar story holds true in the UK and France (Chart I-2 and Chart I-3). Chart I-2Spending On Services Is Still Far Below The Pre-Pandemic Trend In The UK... Chart I-3...And France Still, overall US consumer spending is on trend. Just. But only thanks to an unprecedented largesse of fiscal and monetary stimulus. Begging the question, what will happen when the stimulus ends? If overall stimulated spending is just on trend while spending on services is in deficit, it means that spending on goods is in a mirror-image $420 billion surplus. Which, given the smaller share of spending on goods, equates to 8 percent above where it should be. One misconception is that the surplus in goods spending is concentrated in durables. While this was true six months ago, two-thirds of the current surplus is in nondurables, dominated by clothing and shoes, food and drink at home, and games, toys and hobbies (Chart I-4). Chart I-4US Overspend On Durables Is Now $140 Bn, While Overspend On Nondurables Is $280 Bn Looking ahead, if the demand for goods crashes back to earth, as seems to be happening now, then the demand for services will have to catch up to its pre-pandemic trend. Otherwise there will be a deficit in aggregate demand. So, the crucial question for 2022 is, will services spending catch up to its pre-pandemic trend? Services Spending Will Remain Well Below Its Pre-Pandemic Trend Many people believe that the deficit in US services spending is due to the underspend in bars, restaurants, and hotels. In fact, this is another misconception. The underspending on ‘food services and accommodations’ is now a negligible $30 billion out of the $420 billion deficit. In which case, where is the deficit? Surprisingly, the biggest component is a $160 billion underspend on health care (Chart I-5). In particular, the spending on ‘outpatient physician services’ levelled off a year ago well below its pre-pandemic level (Chart I-6). A plausible explanation is that many doctor’s appointments have shifted to online, requiring much lower spending. The result is that health care consumption has slowed its convergence to the pre-pandemic trend, implying that a deficit could be persistent. Chart I-5US Underspend On Health Care ##br##Is $160 Bn Chart I-6US Spending On Physician Services Is Far Below The Pre-Pandemic Trend A second major component of the deficit is a $110 billion underspend on recreation services, as consumers have shunned the large or dense crowds in amusement parks, sports centres, spectator sports, and theatres. Some of this shunning of crowds will be long-lasting (Chart I-7). Chart I-7US Underspend On Recreation Services Is $110 Bn A third major component of the deficit is a $60 billion underspend on public transportation, as people have likewise shunned the personal proximity required in mass transit systems and aeroplanes. Some of this shunning of transport that requires personal proximity will also be long-lasting (Chart I-8). Chart I-8US Underspend On Public Transportation Is $60 Bn Worryingly, the recent spending on both recreation services and public transportation has stopped converging with the pre-pandemic trend. Admittedly, this might be a blip due to the delta wave of the pandemic, and spending could re-accelerate once this wave subsides. On the other hand, it would be prudent to assume that the delta wave was not the last wave of the pandemic and that further waves could arrive in 2022. Pulling all of this together, large parts of services spending will remain persistently below their pre-pandemic trend. Eventually, new and innovative types of services will plug this deficit, but this will take time. Therefore, we conservatively estimate that, at the end of 2022, US consumer spending on services will still be below its pre-pandemic trend by at least $200 billion, or 2.5 percent. Other major economies, like the UK and France, will suffer similar deficits. Goods Spending Will Crash Back To Earth Let’s now switch to the other side of the ledger, and assess to what extent the underspend in services can be countered by an overspend in goods. Spending on durables is already crashing back to earth. A surplus of $500 billion in March has collapsed to $140 billion now, and we fully expect it to fall back to zero. The reason is that durables, by their very definition, provide long-duration utility. Meaning that there are only so many cars, smartphones, and gadgets that any person can own. But what about the current $280 billion surplus on nondurables – can that be sustained? The biggest component of the nondurables surplus is a $85 billion, or 20 percent, overspend on clothes and shoes. Some of this overspend is justified by a wardrobe transition to the post-pandemic way of working and living. But clothes and shoes, though classified as nondurable, are in fact quite durable. Meaning that once the wardrobe transition is complete, we do not expect people to spend 20 percent more on clothes and shoes than they did before the pandemic (Chart I-9). Chart I-9US Overspend On Clothes And Shoes Is $85 Bn A second major component of the nondurables surplus is a $75 billion, or 7 percent, overspend on food and beverages at home. To a large extent, this has been a displacement of the underspending on eating and drinking out. But given that this underspend on eating and drinking out has almost normalised, we expect the overspend on eating and drinking at home to fade (Chart I-10). Chart I-10US Overspend On Food And Drink At Home Is $75 Bn A third major component of the nondurables surplus is a $45 billion, or 16 percent, overspend on recreational items: games, toys, hobbies, and pets and pet products (Chart I-11 and Chart I-12). To a large extent, this has been a displacement of the underspend on recreation services involving crowds, which will last. Hence, we expect the nondurable surplus on recreational items also to last, to the benefit of the animal care sector and the interactive (electronic) entertainment sector. Chart I-11US Overspend On Games, Toys, And Hobbies Is $45 Bn Chart I-12Spending On Pets Is ##br##Booming Pulling all of this together, we expect the $140 billion surplus on durables to disappear fully, and the $280 billion surplus on nondurables to fade to well below $200 billion. Therefore, given that the deficit on services is likely to be above $200 billion, there is a high risk of a consumer demand deficit in 2022. Four Investment Conclusions The ultra-long end of the bond market is figuring out that without sustained above-trend demand, you cannot get sustained inflation. And to repeat, if demand is barely on trend after an unprecedented largesse of fiscal and monetary stimulus, then what will happen when the stimulus ends? All of which leads to four investment conclusions: Stay overweight 30-year T-bonds. In the equity market, underweight the ‘reflation’ sectors: specifically, underweight banks and basic resources. Stay overweight animal care. Overweight the interactive entertainment sector (look out for a Special Report on this sector coming out very soon). Gas Distribution Is Oversold Finally, one of the paradoxes of skyrocketing natural gas prices is that it has badly hurt the gas distributors which, for the most part, have not been able to pass on the higher prices in full to end users. The resulting margin squeeze has caused a sharp recent underperformance, which is now fragile on its 65-day/130-day composite fractal structure (Chart I-13). Chart I-13Gas Distribution Is Oversold Given this fractal fragility combined with the recent correction in natural gas prices, a recommended trade would be to overweight global gas distribution versus banks, setting a profit target and symmetrical stop-loss at 5 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields ##br##- Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights We introduce our rotation graphs to assess the evolution of the relative trend and momentum of various assets. US equities remain on firm footing, but their weakening relative momentum suggests that investors may soon begin to rotate away from this market in favor of the Eurozone and EM. Cyclicals continue to dominate defensives, globally and in Europe. European value stocks are experiencing improving momentum, which suggests that a rotation out of growth equities is afoot. While European small-cap equities sport attractive fundamentals, rotational dynamics indicate it is still too early to overweight them aggressively. The energy crisis is a dominant driver of the relative sector performance in Europe and resulted in a massive shift in leadership from industrials to energy. As long as oil and natural gas act as a drag, industrials will lag. Financials are well supported. Swedish stocks have borne the brunt of the energy price spike, while Norwegian equities have been its main beneficiaries. The improvement in momentum of German stocks suggests that their relative underperformance will soon end. Spanish shares look attractive from a tactical perspective. Swiss industrials will need a recovery in EUR/CHF to outperform other European industrials. UK industrials will continue to outperform their continental competitors, while Spanish industrials have a window through which to shine. A rotation into UK financials may soon begin as their momentum improves. The darkest days for German financials are ending, while Spanish, Italian, and Swedish financials may soon witness a wave of underperformance. Spanish consumer discretionary equities are becoming more attractive compared to their European counterparts. While Dutch names continue to outperform other European tech equities, their softening momentum suggests investors are beginning to rotate out of this country. Spanish and German tech names offer an attractive diversification opportunity within the industry. Feature Methodology The combination of excess liquidity, large pools of fast money, elevated valuations across most securities, and the existence of the near-term momentum reversal effect encourage investors to rotate from one asset to the next in the hope of rapid profits. Measures to assess where each market stands in this rotational pattern can be useful for investors to catch these swings. In this optic, we introduce our rotation screener focused on equities. It is a simple tool that looks at whether a sector or a country is strengthening relative to its benchmark and whether this strength is happening at a faster or slower momentum. To measure each dimension, we use proprietary indicators of relative strength and momentum. Once each asset’s relative strength and relative momentum are established, we can position them in quadrants. We follow traditional terminology. The upper right quadrant denotes “Leading” assets, or securities that are outperforming their benchmark with strengthening momentum. The bottom right quadrant denotes “Weakening” assets, or securities that are outperforming their benchmark but with a deteriorating momentum. The bottom left quadrant denotes “Lagging” assets, or securities that are underperforming with decreasing momentum. Finally, the top left quadrant indicates “Improving” assets, or securities that are underperforming but with increasing momentum. Investors should move to overweight assets that are in the Improving quadrants and to underweight assets that are inching toward the “Lagging” from the “Weakening” quadrants. This method is very flexible and can be applied to sectors, countries, styles, and so on, as long as a benchmark is available to generate comparisons. In this report, we will analyze the following from a rotational perspective: global national markets, global cyclicals vs global defensive’s, European cyclicals vs European defensives, European sectors, European national markets, European financials, European consumer discretionaries, and European tech stocks. Global National Markets US equities have moved from the Leading quadrant to the Weakening one as they continue to outperform the global benchmark but with a decelerating momentum (Chart 1). This locates the US market in a risky position that could herald a period of underperformance, especially if global economic surprises accelerate. From a rotational perspective, US stocks could still experience another wave of outperformance over the coming weeks, as momentum has been firming over the past four weeks.   The Euro Area benchmark has fully moved from the Weakening quadrant in August to the Lagging one today. Investors should monitor Europe’s relative momentum closely, because a pick-up from here would push the Eurozone into Improving territory, a warning of an imminent trend change in European relative stock prices. Emerging markets have exited the Lagging zone and moved into the Improving quadrant. The move is far from decisive and remains at risk with Chinese credit growth still decelerating. The recent decline in steel prices in China suggests that construction activity in that economy continues to slow. Thus, as long as Chinese credit flows deteriorate, EM stocks will have trouble moving into the Leading quadrant. Cyclicals Vs Defensives Global defensive equities tried to move into the Leading quadrant at the end of the summer, but, ultimately, they plunged back into Lagging territory as global stocks recovered in October (Chart 2). Meanwhile, global cyclicals moved in the opposite trajectory, shifting from the Lagging quadrant to the Leading one over the past three months. Cyclicals continue to benefit from the general uptrend in the market. Even the recent decline in yields is doing little to boost the performance of defensive equities. The biggest risk to these stocks remains the Chinese economic slowdown. For now, this deterioration has not been large enough to compensate for the general vigour in profits and consumption in advanced economies. However, if inflation worries do not abate, then the Chinese slowdown will become more problematic for global cyclicals as it will raise the spectre of stagflation.  The rotational pattern for European cyclicals vs defensive stocks mimics that of global equities (Chart 3). However, European cyclicals are somewhat softer than their global equivalents, hurt by Europe’s greater exposure to the Chinese business cycle compared to the US’s exposure. European Investment Styles Over the past three months, European investment styles have begun a major shift. Value has moved from the Lagging quadrant to the Improving one, which suggests that flows could push value into the Leading quadrant (Chart 4). Moreover, growth has moved from the Leading quadrant to the weakening one, which created a similar dynamic as the decline in performance of the quality factor. This confirms that the rise in yields is beginning to favour a shift in style from growth to value. Meanwhile, small-cap stocks have tumbled into the Lagging quarter. We do expect attractive returns for European small-cap names over an 18- to 24-month investment horizon. However, we have not moved yet to overweight this sector of the market and rotational patterns confirm it is too early to do so safely. European Sectors Sectors have begun to make some important shifts in European markets (Chart 5). Tech has moved from the Leading quadrant to the weakening one. While the sector continues to outperform, it is doing so with a declining momentum, and it could soon move to the Lagging quadrant. This deteriorating price action must be monitored closely. Consumer discretionary names, which were strong performers that have become increasingly weak, have moved from the Weakening quadrant to the lagging one. However, their momentum is not deteriorating as much as it did nine weeks ago, which suggests a move to the Improving quadrant could soon be in the offing. Financials have greatly enjoyed the uptick in global yields. After a short passage through the Lagging quadrant, they have shifted into the Leading one. This suggests that the winds remain behind this sector, which we continue to overweight. Industrials and energy have become mirror images of one another, highlighting the negative impact on European economic activity and profitability of the recent surge in energy prices. The industrials have moved from the Leading quadrant to the lagging one, as the energy sector experienced the opposite direction of travel. This suggests that industrials will only recover their shine once the energy crisis abates, which will also hurt energy stocks. European National Markets The rotational pattern exhibited by European national markets bears their respective sectoral footprints (Chart 6). The tech-heavy Dutch market has moved from the Leading quadrant to the Weakening one, the industrials-focused Swedish market has fallen into the Lagging quadrant from the Weakening one and the Norwegian market has leapt out of Lagging into Leading territory. Hence, if the rotation out of tech deepens, The Netherlands will tumble directly into the Lagging zone, while an easing in energy prices will force Norway and Sweden to switch places on the back of a rotation out of energy into industrials. Germany is of particular interest. It is a well-diversified market that has become oversold. Moreover, as we wrote in September, its relative performance exhibits a significant discount to relative earnings. From a rotational perspective, Germany is moving to leave the Lagging quadrant; a durable shift into the Improving quadrant will sufficiently assuage traders into buying this market. This process will support our overweight position in German equities. Spain is another market we like on a tactical basis. Over the course of the past three months, it moved out of Lagging territory into the Improving zone. This price action supports our thesis that the large country-discount embedded across Spanish equity sectors is excessive and should soon dissipate. The main risk to this view would be another down leg in bond yields, which would hurt financials—a major weight in this market. Italy, too, is in the process of executing a full rotation, having exited the Weakening quadrant and moved into the Lagging one. Italian stocks have tried to punch their way into the Improving zone but have failed to do so. They will require higher yields to move out into the Improving zone durably because of the heavy financials weighting of Italian stocks. European Industrials Within European industrials, a rotational pattern is also evident (Chart 7). Swiss industrials have moved out of the Leading quadrant into the Lagging one as the Swiss franc continues to appreciate against the euro. The rising CHF imparts deflationary pressures into Switzerland and the SNB continues to build up its reserves. As a result, EUR/CHF will appreciate once EUR/USD finds a firmer footing. Thus, while it is too early to overweight Swiss industrials relative to those of the Eurozone, their oversold nature suggests that a rotation in favour of Swiss manufacturing businesses will soon take place. At the current juncture, Spanish industrials look appealing. They have moved out of the Lagging quadrant into the Improving one as the momentum of their relative performance improves. Additionally, they are close to moving into the leading territory. This picture is consistent with a narrowing of the discount embedded in all Spanish sectors since the pandemic broke out. Swedish industrials are also trying to exit the Lagging territory; their elevated RoE, and heavy sensitivity to the DM capex cycle indicate that they should move into the Leading quadrant in the coming weeks. UK industrials have remained in the Leading zone for the past three months, but their relative momentum is softening, which risks them being placed in the Weakening zone. The recent deterioration in GBP/EUR could provide a breath of fresh air, as it will improve the competitiveness of UK industrials compared to continental firms. Even then, for now, rotational dynamics do not flag an imminent problem for UK industrials. European Financials The clearest rotational pattern within European financials may be found in Sweden and the UK (Chart 8). Over the past three months, Swedish financials have fallen out of the Leading quadrant into the Weakening one, and they are inching closer toward the Lagging zone. This suggests that they could soon begin to underperform. Meanwhile, UK financials offer a mirror image as they exited the Lagging quadrant and moved into the improving one. They have yet to enter Leading territory, but seem close to doing so. The pessimism toward the UK is overdone right now. BCA’s Global Fixed-Income Strategy team expects the UK yield curve to steepen anew. UK financials would be prime beneficiaries of this dynamic. Italian and Spanish financials are also exhibiting some concerning moves lately. Both were in the Leading quadrant, but they have since shifted to the lagging one as peripheral spreads widened. Meanwhile, money seems to be moving into German financials, which have advanced from the Lagging quadrant to the Improving quadrant. While they are not as close to the Leading quadrant as their UK competitors, this shift warrants monitoring. European Consumer Discretionary Within the consumer discretionary space, most European countries have remained in their quadrant (Chart 9). Nonetheless, Spanish CD stocks have moved out of the Lagging zone into the Leading quadrant, while their Italian counterparts have recently entered the Weakening quadrant where they have joined French CDs. While both these countries’ consumer discretionary firms are witnessing weakening momentum, they remain in an upward trend against their European competitors. It is therefore too early to sell these countries within this industry. German Consumer discretionary equities are still in the Lagging quadrant, but they are trying to move into the Improving one, where UK CD names have remained for the past three months. European Tech The European tech sector is very much a story about The Netherlands versus the rest, due to the large size of the Dutch tech sector (Chart 10). For now, rotational patterns remain in favour of Dutch names; they have exited the Leading quadrant, but, while their momentum is weakening somewhat, they remain in a pronounced relative uptrend. A few small markets offer some promise. Over the past three months, both Spanish and German tech names have shifted from the Lagging quadrant into the Improving one. Their elevated momentum measures suggest that a shift into the Leading quadrant is imminent. As such, investors should consider switching some of their tech holdings into these two countries to diversify away from the Dutch behemoth.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Special Report

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

Highlights The circumstances of the pandemic improved in October, but data highlighting the economic consequences of the Delta wave grew more severe. US economic activity slowed meaningfully in the third quarter, driven by lower car sales and a slowdown in services spending. The imminent vaccination of school-aged children, and signs that services activity and spending are increasing, will likely raise labor force participation, boost education employment, and hasten the return of real services spending back to pre-pandemic levels. Investors have the right bond view, but the wrong reason. Investors believe that the Fed will be forced to raise interest rates earlier than it currently expects to prevent an out-of-control rise in prices, whereas it will likely do so because of a quicker return to maximum employment. Bond yields are likely to move higher over the coming year, but this will be driven by real yields, not inflation expectations. Once the Fed begins to raise interest rates, investors should be on the lookout for signs that market expectations for the real natural rate of interest, or “R-star,” are rising. The Fed’s terminal rate projection is well below nominal potential GDP growth, and a gap between these two measures no longer makes sense. Stocks are likely to generate mid-single digit returns next year, which will beat the returns offered by bonds and cash. But stocks will generate much lower returns compared with those enjoyed by investors over the past year. A benign rise in long-maturity bond yields argues for the outperformance of value versus growth stocks over the coming year. Cyclical stocks are now becoming stretched versus defensives on an equally-weighted basis; stay overweight for now, but a downgrade to neutral may be in the cards at some point next year. Feature Chart I-1The Waning Impact Of Delta Over the past month, the focus of investors has shifted from day-to-day developments to the consequences of the Delta wave of the pandemic. Chart I-1 highlights that, while an estimate of the COVID-19 reproduction rates in advanced economies has recently inched higher, it remains below one and hospitalizations continue to trend lower in most major economies. UK hospitalizations have increased over the course of the month, but remain at a level that is a quarter of their January peak – despite an elevated pace of confirmed cases. In the US, both these cases and hospitalizations continue to fall, trends that are likely to be reinforced by the vaccination of children over the coming weeks. A 50-60% vaccination rate for school-aged children would increase the US vaccination rate by 4-5 percentage points. Vaccinating all children at this rate would increase the total vaccination rate by 7-8 percentage points. In combination with a meaningful level of natural immunity, the vaccination of children is likely to bring the US very close to, if not above, the non-accelerating hospitalization rate of immunity (or “NAHRI”).1 The Delta Hangover While the circumstances of the pandemic improved in October, the economic consequences grew more severe. US economic activity slowed meaningfully in the third quarter, as highlighted by yesterday’s advance release. Chart I-2 highlights that durable goods spending subtracted almost three percentage points from Q3 growth, and that most other components of GDP contributed less to growth in Q3 than in Q2. The significant slowdown in Q3 growth is disappointing, but several factors point toward the conclusion that it is not likely to be sustained: Chart I-3Services PMIs Are Pointing To A Stronger Q4 The Delta wave very likely impacted services spending, which we have highlighted is likely to drive overall consumption over the coming year. Given the ongoing impact of semiconductor shortages on the availability of new cars, it is not surprising that a slowdown in services spending resulted in a significant slowdown in overall growth. After having declined significantly in Q3, Chart I-3 highlights that the US, UK, French, and Japanese October flash services PMI rose anew, underscoring that recent services weakness have been closely linked to the Delta variant of COVID-19 (whose impact is now waning). Chart I-3 also highlights that the US services PMI is currently at a level that has been historically consistent with solid real PCE growth. Finally, while it is true that manufacturing PMIs are being supported by supplier deliveries components, the October output component of the US Markit manufacturing index remained in expansionary territory, as was the case in Germany, Japan, and the UK (despite month-over-month declines in these components). Chart I-4 highlights that Q3’s real GDP reading was highly anomalous relative to the pace of jobs growth in the quarter, based on the relationship between the two since the global financial crisis. In quarters in which real GDP growth was 1% or less than implied by the trendline shown in Chart I-4, real GDP accelerated in the subsequent quarter 80% of the time. In conjunction with a pickup in services activity in October, this suggests that growth will be meaningfully stronger in Q4. Chart I-5Global Growth Is Peaking, But A Major Downturn Is Unlikely Chart I-5 shows our global Nowcast indicator, alongside our global LEI. Our Nowcast indicator is a high-frequency measure of economic activity that is designed to predict global industrial production. The chart shows that both the Nowcast and global LEI are declining, but that this decline is occurring from an extremely elevated level. The global economy is at an inflection point in terms of the pace of growth, but Chart I-5 still points to above-trend growth – and certainly not a major cyclical downturn. The expectation of a slowdown in growth in Q3 has significantly raised concerns about a possible return to 1970s-style stagflation in the minds of many investors. We address this topic in depth in this month’s Special Report, and conclude that, while investors cannot rule out the possibility of stagflation, there are important differences that point toward a stagflationary outcome over the coming 6-24 months as a risk, not a likely event. We note in our report that the risk of stagflation can be monitored in real time by tracking the Misery Index, which is the sum of headline PCE inflation and the unemployment rate. Currently, the Misery Index is elevated relative to the average of the past 30 years, but it is meaningfully lower than it was during the latter half of the 1970s. This also underscores that true stagflation is only likely to occur if the unemployment rate rises, which means that the economic and financial market outlook over the coming year is strongly tied to the pace of jobs growth (even more so than usual). Table I-1 presents an industry breakdown of the jobs gap relative to pre-pandemic levels, sorted by industries with the largest gap. The table highlights that leisure and hospitality, government, and education and health services jobs continue to account for two-thirds of the five million jobs gap, with the latter two largely reflecting the same effect: 60% of the government jobs gap is accounted for by state and local government education-related employment. Chart I-6Leisure And Hospitality Employment Tracks The Hotel Occupancy Rate US education employment has been impacted by school and classroom closures, which we noted above are likely to end once school-aged children are vaccinated against the disease. Chart I-6 highlights that leisure and hospitality employment is clearly predicted by the US hotel occupancy rate, which wobbled over the past few months as a result of the Delta wave of the pandemic. Correspondingly, monthly growth in leisure and hospitality employment slowed in August and September. Taken together, the imminent vaccination of school-aged children and signs that services activity and spending are increasing will likely raise labor force participation, boost education employment, and hasten the return of real services spending back to pre-pandemic levels. The Bond Market Outlook Chart I-7The Market Now Agrees With Us About The Timing Of Fed Rate Hikes... A continued normalization of the labor market over the coming 6-12 months argues in favor of Fed rate hikes next year, which is a view that we have maintained for several months. Recently, investors have come to agree with us, by moving forward their expectations for the Fed funds rate (Chart I-7). However, Chart I-8 highlights that investors have the right view for the wrong reason. The chart highlights that US government bond yields have risen entirely due to inflation expectations and that real yields have fallen. This means that investors believe that the Fed will be forced to raise interest rates earlier than it currently expects to prevent an out-of-control rise in prices, whereas we believe that they will do so because of a return to maximum employment. The implication for investors is that bond yields are still likely to rise over the coming year, but that higher yields are likely to occur alongside falling inflation expectations. This trend underscores that common hedges against inflation, such as precious metals and the relative performance of TIPS, are likely to underperform over the coming year. We have noted in previous reports that the fair value for long-maturity government bond yields implied by the Fed’s interest rate projections is not likely threatening for equity multiples, and certainly not for economic activity. A September 2022 rate hike, coupled with a pace of three hikes per year and a 2.5% terminal Fed funds rate, implies that 10-year Treasury yields will rise to 2.15% over the coming year, which would be only modestly higher than the level that prevailed prior to the pandemic (Chart I-9). Chart I-8...But For The Wrong Reason Chart I-9Higher Bond Yields Are Unlikely To Be Restrictive Next Year   However, once the Fed begins to raise interest rates, investors should be on the lookout for signs that market expectations for the real natural rate of interest, or “R-star,” are rising. The Fed’s terminal rate projection is well below nominal potential GDP growth, and, while a gap between these two measures made sense in the years following the global financial crisis, this no longer appears to be the case. Chart I-10 highlights that real household mortgage liabilities began to contract sharply in 2006, and did not turn positive on a year-over-year basis until the end of 2016. It is likely that R-star was falling or weak during this period, but the correlation between the two series clearly shifted in the latter phase of the last economic cycle. Chart I-11 emphasizes this point by highlighting that the household debt service ratio is now the lowest it has been since the 1970s, underscoring the capacity that US consumers have to withstand higher interest rates. Chart I-10R-star Fell Post-GFC, For A Time Chart I-11Today, US Households Have A Lot Of Capacity To Tolerate Higher Rates     We doubt that investor expectations for the terminal rate will rise significantly before the Fed begins to normalize monetary policy, but it may happen. In addition, the Fed may begin raising interest rates next year as soon as late in the summer or early in the fall, which would locate the liftoff date within our 6-12 month investment time horizon. As such, our base case view is that a rise in interest rates over the coming year will not be threatening to the equity market, but this view may change at some point next year. Equities: Expect Modest Returns In 2022 A benign increase in long-maturity bond yields in 2022 suggests that equity multiples will neither contribute to, nor subtract from, equity returns. As such, return expectations for equities should be centered around expected earnings growth. Table I-2 presents consensus estimates for nominal GDP growth, S&P 500 revenue growth, and earnings growth for 2022. The table highlights that expectations for revenue growth estimates appear to be reasonable, given that bottom-up analysts continue to expect an expansion in profit margins next year. Chart I-12 highlights that margins have already risen back above their pre-pandemic high, and that this is true for both tech and ex-tech sectors. Chart I-12US Profit Margins Have Already Risen To Record Levels We doubt that further increases in profit margins will be sustained next year. It is possible that margins will actually decline – a view that was recently espoused by our US Equity Strategy service.2 Risks to profit margins underscore that stocks are likely to generate mid-single digit returns next year, which will beat the returns offered by bonds and cash. But stocks will generate much lower returns compared with those enjoyed by investors over the past year. Within the equity market, we remain of the view that even a benign rise in long-maturity bond yields argues for the outperformance of value versus growth stocks over the coming year. Chart I-13 highlights that the rolling one-year correlation between relative global growth versus value stock prices and the US 10-year Treasury yield has become increasingly negative over time, which bodes well for value. We also continue to recommend that investors favor small over large caps and cyclicals over defensives, although cyclical stocks are now becoming stretched versus defensives on an equally-weighted basis as they are closing in on their 2018 highs (Chart I-14). We think it is too early to position against cyclicals, but a downgrade to neutral may be in the cards at some point next year. Chart I-13Growth Will Underperform Value If Long-Maturity Bond Yields Rise Chart I-14Cyclicals Are Starting To Look Stretched Versus Defensives   Investment Conclusions Next month’s report will feature BCA’s 2022 outlook, as well as a transcript of our recently held annual discussion with Mr. X and his daughter Ms. X (who joined his family office a couple of years ago). Our annual outlook will provide a detailed walkthrough of our views for the upcoming year, as well as answers to sobering questions raised by Mr. X and Ms. X about the longer-term outlook. For now, we recommend that investors stick with a pro-cyclical view, favoring the following assets: Global stocks over bonds A short-duration position within a government bond portfolio Speculative-grade corporate bonds within a credit portfolio Global ex-US stocks vs US, focused on DM ex-US Global value versus growth stocks Cyclicals versus defensives, and small versus large caps Major currencies versus the US dollar Jonathan LaBerge, CFA Vice President The Bank Credit Analyst October 29, 2021 Next Report: November 30, 2021 II. Gauging The Risk Of Stagflation In this report we examine the risk of stagflation by comparing the current environment to that of the late-1960s and 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part due to strong goods demand and supply disruptions that will eventually dissipate, and economic agents do not expect severe price pressures to persist beyond the pandemic. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not a likely event. Investors should use the Misery Index, which is the sum of the unemployment rate and headline PCE inflation, as a real-time stagflation indicator. The Misery Index underscores that the US economy is unlikely to experience true stagflation unless the unemployment rate rises. A portfolio of the US dollar, the Swiss Franc, and industrial commodities may serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-1The Misery Index Reflects The Risk Of Stagflation Over the past several weeks, concerns about a possible return to 1970s-style stagflation have re-emerged significantly in the minds of many investors. These investors have pointed toward similarities between the current environment and that of the 1970s, including shortages limiting output, a snarled global trade and logistical system, and rising energy prices. Chart II-1 highlights that the US “Misery Index” – the sum of the unemployment rate and headline PCE inflation – rose again over the past several months to high single-digit territory, after having fallen dramatically from April 2020 to February of this year. Panel 2 of Chart II-1 highlights that last year's rise in the Misery Index was driven almost entirely by the unemployment rate, whereas the current level is due to a combination of a modestly elevated unemployment rate and a pronounced acceleration in inflation. The headline PCE deflator has risen above 4%, a level that has not been reached since 1991 during the First Gulf War. In this report, we examine the risk of stagflation by comparing the current environment to that of the late 1960s and 1970s. We conclude that while investors cannot rule out the possibility of a stagflationary outcome, there are important differences that point toward a stagflation outcome over the coming 6-24 months as a risk, not a likely event. We conclude by highlighting assets that may produce absolute returns in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Revisiting The 1960s And 70s Chart II-2The 1960s Laid The Groundwork For Elevated Inflation The first step in judging the risk of a return to 1970s-style stagflation is to review, in a detailed way, what caused those conditions. Investors are well aware of the role that two separate energy price shocks played in raising prices and damaging output during this period, but they are less cognizant of the impact that a persistent period of above-trend output and significant labor market tightness had in setting up the conditions for sharply higher inflation. This focus of investors on energy prices partially reflects the fact that the Misery Index increased most visibly in the 1970s and that policymakers in the 1960s may not have realized how extensively economic output was running above its potential. With the benefit of hindsight, Chart II-2 illustrates the extent to which inflationary pressures built up in the 1960s, well before the first oil price shock in 1973. The chart shows that the unemployment rate was below NAIRU – the non-accelerating inflation rate of unemployment – for 70% of the time during the 1960s, and that inflation had already responded to this in the latter half of the decade. Annual headline PCE inflation was running just shy of 5% at the onset of the 1970 recession; it fell to 3% in the aftermath of the recession, but had already begun to reaccelerate in the first half of 1973. Following the 1973/1974 recession, inflation did decelerate significantly, falling from 11-12% to 5% in headline terms, and from 10% to 6% in core terms. But the pace of price appreciation did not fall below 5-6% in the second half of the 1970s, despite a significant and sustained rise in the unemployment rate above its natural rate. The 1975 to 1978 period is especially important for investors to understand, because it is arguably the clearest period of true stagflation in the 1970s. The fact that the Misery Index rose sharply during two major oil price shocks is not particularly surprising in and of itself, given the direct impact of energy prices on headline consumer prices; it is the fact that the index remained so elevated between these shocks, the result of persistently high inflation in the face of significant labor market slack, that is most relevant to investors. There are two reasons that both inflation and unemployment remained high during this period. First, labor market slack was sizeable during these years because the US economy was more energy-intensive in the 1970s than it is today. Chart II-3 highlights that goods-producing employment lagged overall employment growth from late 1973 to late 1977, underscoring that the rise in oil prices significantly impacted jobs growth in energy-intensive industries. Second, it is clear that the combination of demand-pull inflation in the late 1960s and the predominantly cost-push inflation of the 1970s led to expectations of persistent inflation among households and firms. The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. But the experience of the 1970s highlighted that inflation expectations are also an important determinant of inflation, a realization that gave birth to the expectations-augmented (i.e. “modern-day”) Phillips Curve (more on this below). The Stagflation Era Versus Today Table II-1 presents a stagflation “threat matrix,” representing the Bank Credit Analyst service’s assessment of the various factors that could potentially contribute to a stagflationary environment today, relative to what occurred in the 1960s and 1970s. While we acknowledge that there are some similarities today to what occurred five decades ago, the most threatening factors have been present for a shorter period of time and appear to have a smaller magnitude than what occurred during the stagflationary era. In addition, key factors, such as the visibility available to policymakers and investors about household inflation expectations and the potential output of the economy, would appear to reduce significantly the risk of a stagflationary outcome today. We discuss each of the factors presented in Table II-1 below: Fiscal & Monetary Policy Chart II-4Government Spending Last Cycle Looked Nothing Like The 1960s The persistently tight labor market that contributed to the inflationary buildup in the 1960s occurred as a result of easy fiscal and monetary policy. Chart II-4 highlights that the contribution to real GDP growth from government expenditure and investment was very elevated in the 1960s. Chart II-5 shows that a positive output gap in the late 1960s and the first half of the 1970s is well explained by the fact that 10-year US government bond yields were persistently below nominal GDP growth. The relationship between the stance of monetary policy and the output gap only meaningfully diverged in the latter half of the 1970s, during the true stagflationary era that we noted above. Chart II-5Easy Monetary Policy Juiced Aggregate Demand In The 60s And Early 70s Chart II-6Monetary Policy Today Is Extremely Easy Today, it is clear that the stance of fiscal policy has recently been extraordinarily easy, and 10-year US government bond yields have remained well below nominal GDP growth for the better part of the last decade. Relative to estimates of potential nominal GDP growth, 10-year Treasury yields are the lowest they have been since the 1970s (Chart II-6). Ostensibly, this supports concerns that policy might contribute to a stagflationary outcome. These concerns were raised by Larry Summers in March, when he described the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.3 But there are two important counterpoints to these concerns. First, easy fiscal policy this cycle has followed a period during the last economic cycle in which government spending contributed to the most sustained drag on economic activity since the 1950s. Unlike the 1960s, the unemployment rate has been below NAIRU for only a third of the time over the past decade. In addition, Chart II-7 highlights that fiscal thrust will turn to fiscal drag next year, underscoring the temporary nature of the massive burst in fiscal spending that has occurred in response to the pandemic. Under normal circumstances, the fiscal drag implied by Chart II-7 would substantially raise the risks of a recession next year, but we have noted in previous reports that a significant amount of excess savings remain to support spending and employment. The net impact of these two factors results in a reasonable expectation that the US economy will return to maximum employment next year, but this is a far cry from the 1960s when the unemployment rate was below its natural rate for 70% of the decade. Based on conventional measures, US monetary policy has been easy for a decade, but easy monetary policy did not begin to contribute positively to a rise in household sector credit growth last cycle until 2014/2015. This underscores that the natural rate of interest (“R-star”) did fall during the early phase of the last economic expansion. However, we argued in an April report that R-star was likely rising in the latter half of the last expansion,4 and we believe that the terminal Fed funds rate is likely higher than what the Fed is currently projecting, barring any additional negative policy shocks. Thus, while we do not believe that the duration of easy monetary policy over the past decade has laid the groundwork for a major rise in prices, it is now clearly positively contributing to aggregate demand and does risk a future overshoot in prices if long maturity bond yields remain well below the pace of economic growth for a sustained period of time. The Impact Of Shortages Chart II-8Gasoline Shortages Plagued The US Economy In The 1970s Gasoline shortages occurred during the oil shocks of the 1970s and are a key similarity that some investors point toward when comparing the situation today with the stagflationary era. Chart II-8 highlights that the annual growth in real personal consumption expenditures on energy goods and services fell into negative territory on six occasions in the 1970s, although it was most pronounced during the two oil price shocks and their resulting recessions. Today, the impact of shortages appears to be broader than what occurred in the 1970s, but less impactful and not likely to be as long-lasting. Chart II-9 highlights that the OPEC oil embargo of 1973 raised the global oil bill by 2.4% of global GDP and permanently raised the price of oil. The global oil bill will only be fractionally above its pre-pandemic level in 2022, with oil prices at $80/bbl, and, while it is true that US gasoline prices have risen significantly, they are not higher than they were from 2011-2014 (Chart II-10). Chart II-9$80/bbl Oil Is Not Onerous Chart II-10US Gasoline Prices Are High, But They Have Been Higher It is certainly true that global shipping costs have skyrocketed and that this is contributing to the increase in US consumer prices. We estimate, however, that this increase in shipping costs as a share of GDP is no more than a quarter of the impact of the 1973 increase in oil prices, without the attendant negative effects on US goods-producing employment that occurred in the 1970s. If anything, surging shipping costs create an incentive to re-shore manufacturing production, which would contribute positively to US goods-producing employment. We also do not expect the rise in shipping costs to be meaningfully permanent, i.e., shipping costs may ultimately settle at a higher level than they were in late-2019, but at a much lower level than what prevails today. Chart II-11A Tight Labor Market Is Causing Wage Growth To Pick Up Semiconductor and labor shortages would appear to represent a more salient threat of stagflation in the US, as the domestic production of motor vehicles cannot occur without key inputs and a tight labor market is already contributing to an acceleration in wage growth (Chart II-11). As we noted in Section 1 of our report, auto production significantly impacted growth in the third quarter. However, Chart II-12 highlights that, for now, the breadth of impact of these shortages appears to be limited: the production component of the ISM manufacturing index remains in expansionary territory, industrial production of durable manufacturing excluding motor vehicles and parts has not broken down, and both housing starts and building permits remain above pre-pandemic levels despite this year’s downtrend in permits. Chart II-12Shortages Do Not Yet Seem To Be Broad-Based A physical shortage of components is a less relevant factor for the services side of the economy, which appears to have re-accelerated meaningfully in October. The services sector is more considerably impacted by shortages in the labor market, which seem to be linked to a still-low labor force participation rate. We noted in our September report that the decline in the participation rate has significantly overshot what would be implied by the ongoing pace of retirements. Chart II-13 highlights that this has occurred not just because of a significant retirement effect, but also because of the shadow labor force (people who want a job but are not currently looking for work) and family responsibilities. We expect that the recent expiry of expanded unemployment insurance benefits, a steady rise in the immunity of the US population, an abating Delta wave of COVID-19, and a likely upcoming reduction in school/classroom closures once the Pfizer/BioNTech vaccine is approved for school-age children will likely ease the labor shortage issue over the coming several months. Output Gap Uncertainty It remains a debate among economists why policymakers maintained such easy monetary policy in the 1960s and 1970s, but Chart II-14 highlights that uncertainty about the size of the output gap may have contributed to too-low interest rates. The chart shows the unemployment rate compared with today's estimate of NAIRU, alongside a simple proxy for policymakers’ real time estimate of the natural rate of employment: the cumulative average unemployment rate in the post-war environment. To the extent that policymakers used past averages of the unemployment rate as their guide for NAIRU, Chart II-14 highlights how they may have underestimated the degree to which output was running above its potential level in the 1960s, and would not have even concluded that output was above potential in the early 1970s. Chart II-14Policymakers Overestimated Labor Market Slack In The 60s And 70s Chart II-15Policymakers Know That NAIRU Is Likely At Or Below 4% Today, the environment is quite different, because the acceleration in wage growth at the tail end of the last expansion gives policymakers and investors a good estimate of where NAIRU is. Chart II-15 highlights that wage growth accelerated in 2018/2019 in response to a sub-4% unemployment rate, which is consistent with both the Fed’s NAIRU estimate of 3.5-4.5% and Fed Vice Chair Richard Clarida’s expressed view that a 3.8% unemployment rate likely constitutes maximum employment (barring any issues with the breadth and inclusivity of the labor market recovery). It is possible that the pandemic has structurally lowered potential output, which could mean that policymakers may no longer rely on the wage growth / unemployment relationship that existed in the latter phase of the last expansion. However, we do not find any credible arguments that would support the notion of a structurally lower level of potential output: the pandemic is likely to end at some point in the not-too-distant future, the negative impact of working-from-home policies on office properties and employment in central business districts is not sizeable,5 and productivity may have permanently increased in some industries because of the likely stickiness of a hybrid work culture. The Behavior Of Inflation Expectations Chart II-16Rising Long-Term Expectations Have Merely Normalized (For Now) One parallel to the argument that policymakers may have underestimated the degree of labor market tightness in the 1960s and early 1970s is the fact that they did not yet understand that inflation expectations are an important determinant of actual inflation, nor were they able to monitor them even if they did. Most credible surveys of inflation expectations began in the 1980s, and policymakers in the 1960s and 1970s were guided by the original Phillips Curve that solely related inflation to unemployment. Today, policymakers have the experience of the stagflationary episode to serve as a warning not to allow inflation expectations to get out of control, and both policymakers and investors have reliable measures of inflation expectations for households and market-participants. Chart II-16 highlights that households expect significant inflation over the coming year, but also expect prices over the longer term to rise at a pace that is almost exactly in line with their average from 2000-2014. The Rudd Controversy: (Adaptive) Inflation Expectations Do Matter One potential criticism of the idea that inflation expectations are signaling a low risk of higher future inflation has emerged through arguments made by Jeremy Rudd, a Federal Reserve economist. In a recent paper, Rudd questioned the view that households’ and firms’ expectations of future inflation are a key determinant of actual inflation; he suggested instead that relatively stable inflation since the mid-1990s might reflect a situation in which inflation simply does not enter workers’ employment decisions and expectations are irrelevant. Rudd’s paper was primarily addressed to policymakers who view inflation dynamics in a highly quantitative light. A full response to the paper would be mostly academic and thus not especially relevant to investors; however, we would like to highlight three points related to the Rudd piece that we feel are important.6 First, we disagree with Rudd’s argument that the trend in inflation has not responded to changes in economic conditions since the mid-1990s. Chart II-17 highlights that while the magnitude of the relationship has shifted, the trend in inflation relative to a measure of long-term expectations based on prior actual inflation has mimicked that of the output gap. The fact that inflation was (ironically) too high during the early phase of the last economic cycle provides some support for Rudd’s inflation responsiveness view, although we would still point toward the Fed’s strong record of maintaining low and stable inflation, its active communication with the public in the years following the global financial crisis, and the fact that a recovery began and the output gap began to (slowly) close as the best explanation for the avoidance of deflation during that period. Second, we agree with Rudd’s point that regime shifts in inflation’s responsiveness to economic conditions can occur, and that adaptive measures of inflation expectations, and even surveys of inflation, may not capture such a shift in real time. Chart II-18 shows that the 2014-2016 period was a good example of this, when adaptive expectations as well as household survey measures of long-term inflation expectations both lagged the actual decline in inflation that was caused by a collapse in the price of oil. Chart II-17The Trend In Inflation Continues To Respond To Economic Conditions Chart II-18Surveyed Inflation Expectations Can Lag, But This Time They Led But Chart II-18 also shows that long-term household survey measures of inflation led the rise in actual inflation (and thus our adaptive expectations measure) last year, underscoring that these measures are likely more reliable indicators today of whether a major regime shift is occurring. As noted above, long-term expectations have risen significantly relative to what prevailed prior to the pandemic, but this has merely raised expectations from extraordinarily depressed levels back to the average that prevailed prior to (and immediately after) the global financial crisis. Therefore, household expectations are not yet at dangerous levels. Chart II-19Unit Labor Costs Modestly Lead Inflation, But Are Far From Extreme Third, one of the core observations in Rudd’s paper is that unit labor cost (ULC) growth leads the trend in inflation, which he argued was evidence against the idea that expectations of future inflation are a key determinant of actual inflation. Chart II-19 highlights that Rudd is correct that ULC growth modestly leads inflation (especially core inflation), but we disagree with his conclusion that it argues against the importance of expectations. As we noted in Section 2 of our January 2021 Bank Credit Analyst,7 one crucial aspect of the expectations-augmented, or “modern-day” Phillips Curve is that, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. Our view is that ULC growth is fundamentally linked to slack in the labor market, which is directly incorporated in output gap measures. As we noted above, investors currently have a good estimate of the magnitude of the output/employment gap, meaning that it is possible to track the inflationary consequences of prevailing aggregate demand. As a final point about ULC growth, Chart II-19 highlights that while the five-year CAGR of unit labor costs is currently running at its strongest pace since the global financial crisis, investors should note that it remains well below the levels that prevailed in the late-1960s when persistently above-potential output laid the groundwork for a massive inflationary overshoot. Conclusions And Investment Strategy Our review of the 1960s and 1970s highlights that stagflation is a phenomenon in which supply-side shocks raise prices of key inputs to production, which lowers output and raises unemployment. Energy price shocks in the 1970s occurred after a long period of policy-driven above-trend growth in the 1960s, meaning that both demand-pull and cost-push inflation contributed to stagflation in the 1970s. Today, investors cannot rule out the possibility of a stagflationary outcome, for four reasons: long-term household inflation expectations have risen significantly over the past year; fiscal policy has been very expansionary; monetary policy will remain expansionary at the Fed’s projected terminal Fed funds rate; and component shortages and price increases linked to energy market and supply chain disruptions may persist or worsen over the coming year. Chart II-20It Is Not Stagflation If The Unemployment Rate Continues To Fall However, the strong demand-pull inflationary dynamics that existed in the late-1960s were mostly absent in the lead-up to the pandemic, supply-chain issues are in part the result of strong goods demand and disruptions that are clearly linked to the pandemic (and thus will eventually dissipate), and long-term inflation expectations are behaving differently than short-term expectations, signaling that economic agents do not expect severe price pressures to persist beyond the pandemic. Policymakers also have more visibility about the magnitude of economic / labor market slack than they did during the stagflationary era and better tools to track inflation expectations. On balance, this points to a stagflationary outcome over the coming 6-24 months as a risk, but not as a likely event. Using the Misery Index as real-time stagflation indicator, investors should note that the US economy is not likely experiencing true stagflation unless the unemployment rate rises. Chart II-20 highlights that there is no evidence yet of a contraction in goods-producing or service-producing jobs. Even if goods-producing employment slows meaningfully over the coming few months as a result of component shortages, the unemployment rate is still likely to fall if services spending normalizes, as it would imply that the gap in services-producing employment, which is currently 20% of the level of pre-pandemic goods-producing employment, will continue to close. Investors have been focused on the issue of stagflation because its occurrence would imply a sharply negative correlation between stock prices and bond yields. This is not our base case view, but we have highlighted that months with negative returns from both stocks and long-maturity bonds tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). As we discussed in Section 1 of our report, we do expect the Fed to raise interest rates next year. We do not see a rise in bond yields to levels implied by the Fed’s interest rates projections as being seriously threatening to economic activity, corporate earnings growth, or equity multiples. But the adjustment to higher long-maturity bond yields may unnerve equity investors for a time, implying temporary periods of a negative stock price / bond yield correlation. Table II-2 highlights that, since 1980, commodities, the US dollar, and the Swiss franc have typically earned positive returns during non-recessionary months in which stock and long-maturity bond returns are negative. While the dollar is not likely to perform well in a stagflationary scenario, Chart II-21 highlights that CHF-USD and industrial commodities performed quite well in the late-1970s. As such, a portfolio of these three assets might serve as a useful hedge for investors who are concerned about absolute return prospects in a world in which long-maturity bond yields are rising and risks of stagflationary dynamics are present. Chart II-21The Swiss Franc and Raw Industrials Did Well During The Stagflationary Era 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 technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises appear to have peaked, but there is not yet any meaningful sign of waning forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we would continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yield. The US 10-Year Treasury yield remains above its 200-day moving average after failing to break meaningfully below it. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that a move higher over the coming year is likely. However, most of the recent move higher in government bond yields has occurred due to rising inflation expectations, whereas the increase in yields over the coming year will likely occur in real terms. Commodity prices remain elevated, and our composite technical indicator highlights that they are still overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, may weigh on commodity prices at some point over the coming 6-12 months. US and global LEIs remain very elevated but have started to roll over. 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 is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. 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 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 Section 1 of the September 2021 Bank Credit Analyst for a detailed discussion of the US immunity level. 2  Please see US Equity Strategy "Marginally Worse," dated October 11, 2021, available at uses.bcaresearch.com 3  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 4 Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com 5 Please see The Bank Credit Analyst “Work From Home “Stickiness” And The Outlook For Monetary Policy,” dated June 24, 2021, available at bca.bcaresearch.com 6 Rudd, Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?),” Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System. 7  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December 18, 2021, available at bca.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: