Economy

Special Report

Executive Summary Energy Industry Is Driven By Multi-year Capex Cycles Demand: Crude oil demand is expected to return to trend driven by strong economic growth and the receding pandemic. Supply: Production remains suppressed because of curtailments by OPEC 2.0 members, investment restraint from US producers, and multiple supply disruptions. To meet the increasing oil demand, the US shale oil producers are now perfectly positioned to pick up slack in supply. New Capex Cycle: The industry’s Capex is inherently cyclical – there are early signs of the new “up” leg.  Geopolitics: Sizzling tensions with Iran, Russia, and a possible new market share war with the Saudis may lead to volatility in crude oil prices. Bottom Line: The US Energy sector is in the early innings of the new Capex and production cycle on the back of growing demand for oil and gas, and faltering supply from OPEC 2.0 members. Stay tuned for an upcoming Part II of the report where we will provide investment recommendations for the Energy sub-sectors. Feature This week, we start a “deep dive” into the Energy sector, aiming to make an educated decision regarding Energy sector allocations – is it time to take profits after a strong run, or does the rally still have legs? We are currently overweight Energy, with the position outperforming the S&P 500 by 32% since we initiated it in December 2021. This is a two-part report. In today’s publication, we will overview the industry landscape, and analyze global supply and demand for oil, price forecasts, and geopolitical undercurrents. Next week, we will cover the Energy sector’s macroeconomic backdrop, fundamentals, and valuations. We will use the analysis to provide investment recommendations for the sector, as well as offer a granular view on the prospects of each Energy industry group. Stay tuned! Performance All of a sudden, the Energy sector, a humble chronic underperformer, the weight of which in the S&P 500 has melted from 15% to 5% over the past 15 years, is hot again and is a focal point of investor attention. Indeed, Energy was the best performing sector in 2021 and is the only sector with positive absolute returns YTD, outperforming the S&P 500 by 30%. Despite a strong recent run, Energy is still 18% behind the S&P 500 since January 2020, and 72% since 2008 (Chart 1). Chart 1Energy Has Lagged The S&P 500 Since 2020 Table 1 The Early Innings Of A New Capex Cycle The energy industry is inherently cyclical, driven by multi-year Capex cycles. Supply shortages and high oil prices beget years of elevated capital spending, which boosts production to unsustainable levels. Once the market is flooded with oil, prices collapse, and “seven lean years” of underinvestment commence (Chart 2). Case in point: Energy industry Capex has been in a downcycle since 2014 when Saudi Arabia flooded the market with oil to protect its market share and confront Iran. Recent supply shortages have been further exacerbated by a broad push towards “green” energy, fortified by government incentives, regulations, and shareholder activism directed against fossil fuels. Just last year, a hedge fund called Engine No. 1, backed up by BlackRock, Vanguard, and State Street, installed three new directors on Exxon’s board with a declared effort to force the company to reduce its carbon footprint. Politicians’ and investors’ aversion to the “dirty sources of energy” translates into a higher cost of capital for oil producers and reluctance to invest despite rising prices. Ironically, “greenification” has led to a higher price of oil and constrained output – producing a profit windfall for the oil and gas producers. Chart 2Energy Industry Is Driven By Multi-year Capex Cycles Further, not only were oil producers overly cautious and concerned about the sustainability of higher oil prices but also, once compelled to go ahead with multi-million-dollar investments, they could not react fast enough – it takes six to eight months to ramp up production. This explains the recent dichotomy between the WTI and the Energy sector return (Chart 3). Chart 3Dichotomy Between WTI And Energy Sector Returns Chart 4Rig Count Is Rising Again Now that the industry is flush with cash and gaining confidence in the sustainability of higher prices, it is cautiously increasing production and adding rigs. Capex is expected to rise by 25% year-over-year in 2022, and by 7% in 2023. Rig count increased by 11% in 2021 (Chart 4). Industry Structure Energy Sector Composition The energy sector consists of four distinct segments, with each segment corresponding to a section of the oil production value chain (Figure 1). The GICS sector classification classifies them as Oil & Gas Exploration and Production (aka E&P or Upstream segment), Oil & Gas Equipment and Services Companies, Storage and Transportation (Midstream), and Refining and Marketing (Downstream). Integrated Oil & Gas companies straddle the entire supply chain. Integrated Oil Companies constitute almost half of the S&P 500 Energy sector, with E&P at just over a quarter (Chart 5). The Energy sector is not as top heavy as some of its “new technology” brethren in the overall market index. Of all the segments, Midstream has the highest margins, as its fees are a function of output as opposed to the price of oil (Chart 6). Energy Services is most challenged as its revenue is a function of E&P Capex and is highly leveraged to the oil price. Figure 1The Energy Industry Supply Chain Chart 5The Sector Is Dominated By E&P And Integrated Oil Companies Chart 6Profitability Varies Across Segments Upstream: E&P Segment This segment is the first step in the production process. E&P companies focus on exploration, discovery, and managing the production of new and established wells. The success of these companies is largely a function of their ability to find new profitable oil and gas deposit sites. Development of new rigs is a sophisticated technological process that requires hundreds of millions of dollars in capital outlays without much guarantee of success. In addition, tight oil (aka shale) wells have steep declines in the early years of their production, requiring continuous drilling of new wells to maintain production rates. The E&P companies also have to constantly look for and develop new extraction sites. This is the riskiest energy segment – the E&P companies must manage the dual uncertainty of the exploration process and of the price of crude, for which they are perfect price-takers. As a result, E&P stocks have the highest beta of all segments to the price of oil. In this business, economies of scale and diversification certainly help profitability – larger companies in the sector tend to have a higher RoE (Chart 7). The largest and most well-known upstream companies are ConocoPhilips (COP), EOG Resources (EOG), and Pioneer Natural Resources (PXD). The E&P ETF is XOP. Chart 7Larger Companies Tend To Have A Higher RoE Energy Equipment And Services (E&S) Segment This segment supplies equipment and services, such as drilling, to the E&P companies. Once a new oil or gas discovery is vetted and gets the go-ahead, upstream companies allocate resources for the development of a new site. To put it simply, upstream companies’ Capex is E&S firms’ revenue. In addition, the E&S companies maintain existing wells, retire depleted ones, and complete unfinished wells (as is happening now). Consequently, this sub-sector is tightly linked to the well-being of exploration companies, and through them, to the crude oil and gas prices. Over the past seven “lean years”, upstream companies’ newly-found Capex discipline, and a push to return cash to shareholders, was quite a blow for the E&S companies. To survive, many had to look for new sources of revenue, such as servicing green energy projects. Recent oil and gas shortages and a rising rig count are a notable change of fortune for these companies. However, the E&P companies are still in a frugal and cautious mindset and are focusing on the completion of drilled-but-uncompleted wells (DUCs), whose number has decreased by 29% in 2021.1 This work is less lucrative for the E&S companies than drilling new wells. Some of the largest players in the industry are Baker Hughes (BKR), Halliburton (HAL), and Schlumberger (SLB). The ETF is XES. Midstream: Storage And Transportation (S&T) Segment S&T companies are involved in the transportation, storage, and trading of unrefined oil after it has been taken out of the ground by the upstream firms. There are several modes of oil transportation: Marine vessels, trucks, and pipes. While the first two modes are straightforward, it is pipelines that put the overall energy industry into political crosshairs. Since pipelines must go through someone’s land, midstream companies often get caught in land rights or related environmental battles. As a result, the industry is heavily regulated, and many projects are blocked and dropped after multi-year delays and millions in legal fees. But all in all, this segment faces less uncertainty than other segments as its sales are a function of production volume as opposed to the price of oil. It also requires more moderate capital outlays than the upstream segment. Kinder Morgan (KMI), ONEOK (OKE), and Williams (WMB) are the key players in this space. Downstream: Refining And Marketing (R&M) Segment Refining and marketing crude oil completes the energy industry value chain. Refining is a complex process that transforms raw crude that has little use into end-user products such as motor fuel, heating oil, or plastics. These products are then marketed for distribution on a wholesale basis to be sold to the consumer, business, and government sectors. Refiners run mostly high fixed cost operations and benefit from higher volumes. These companies are less sensitive to the price of crude as they make money on the crack spread, or the difference between the price of raw and refined oil. In 2021, utilization rates of refiners got back to 90% of pre-pandemic levels. Marathon Petroleum (MPC), Valero Energy (VLO), and Phillips 66 (PSX) are the three R&M companies in the S&P 500 Energy benchmark. Integrated Oil And Gas (Integrated) While most players in the industry typically specialize within their segment, Chevron (CVX), ExxonMobil (XOM), and Occidental Petroleum (OXY) are exceptions. These are vertically integrated companies that operate in every segment of the value chain, from upstream to downstream. These are the largest and most diversified industry players, less dependent on the price of oil or Capex cycle than companies in the other segments. Oil And Gas Consumption For many laymen, like myself, oil and gas stand for driving and cooking. However, the uses of energy products are diverse and touch nearly every sector of the global economy. According to EIA (Figure 2), in 2020, motor gasoline stood for 44%, jet fuel for 6%, and hydrocarbons for 18% of overall oil and gas output. In terms of sectors, 66% went to the Transportation sector, and 28% to the Industrial sector for example as plastics. In 2022, we expect a further pick-up in demand for fuel from the aviation industry, and from car drivers – as COVID-19 gradually morphs from a pandemic into an endemic illness, and demand for travel increases. Figure 2US Petroleum Products Consumption By Source And Sector, 2020 Supply And Demand Oil Demand Recovery To Continue EIA reports that “global oil consumption outpaced oil production for the six consecutive quarters, ending with the fourth quarter of 2021 (4Q21), which has led to persistent withdrawals from global oil inventories and significant increases in crude oil prices”.2 According to BCA Research’s Chief Commodity and Energy Strategist Bob Ryan, demand will continue to return to trend (Chart 8), barring too-high prices or another full-scale COVID-induced lockdown in a key market like China. He also emphasizes that increase in oil demand is being driven by economic growth, and consumers are likely to withstand higher prices, as long they don’t become entrenched at over $90/bbl. We concur. Chart 8Global Oil Demand Expected To Get Back On Track Supply From OPEC 2.0 Is Faltering – US Shale To The Rescue! Crude oil production remained suppressed because of curtailments by OPEC 2.0 members, investment restraint from US oil producers, and other supply disruptions. To meet the increasing oil demand, the core OPEC 2.0 member states ex-Russia, i.e., Saudi Arabia, Iraq, the UAE, and Kuwait, need to restore production taken off the market in the wake of the pandemic. According to the Oxford Institute of Energy Studies (OIES), this year OPEC 2.0 "will struggle to return more than 2 mb/d of withheld supplies in 2022, compared to the headline target of 3.76 mb/d."3 In the face of ongoing downgrades in the inability of OPEC 2.0 member states, including Russia, to increase output, the US shale oil producers need to pick up slack in supply. BCA’s Commodity & Energy Strategy (CES) projects that, in 2023, US crude oil production will return to the pre-pandemic high (Chart 9). Chart 9US Oil Production Has To Increase So far the increase in US output has been slow, mostly because it takes six to eight months after an oil price increase to assemble rigs and crews to significantly lift production from current levels.4 Supply And Demand – Mostly Balanced With oil demand normalizing, and US shale producers gearing up to make up shortfalls from OPEC 2.0 producers, markets are likely to remain balanced (Chart 10). The implication is price stability barring geopolitical shocks (which may be many). Chart 10Market Remains Tight But Mostly Balanced Chart 11Brent Forecasts Center Around /bbl For 2022 Price Forecasts On the back of faltering oil supply from OPEC 2.0 and steady demand recovery, BCA’s CES forecasts the Brent oil price to average $80/bbl this year, and $81/bbl in 2023. This call is in line with market consensus, with most estimates clustered around the $80-$85/bbl range. EIS forecasts are more conservative – WTI is set to decline from the current price of $90 to $75 in 2022, and $68 in 2023 (Chart 11). To put these prices into context: $46/barrel is a breakeven cost of a well in the Permian Midland, and $64 is an average WTI price used by executives for planning their Capex in 2022.5 Geopolitical Tensions: Uncertainty Will Lead To Oil Price Volatility Supply shortages, due to OPEC 2.0’s inability to raise output, coupled with a time lag in restarting US shale rigs, are exacerbated by geopolitical tensions involving Iran and Russia. According to BCA Research’s Geopolitical Strategist Matt Gertken, we are to expect significant volatility in oil and gas prices due to uncertainty associated with Iran and Russia. The US is seeking to rejoin the 2015 nuclear deal, which would be a stop-gap solution to tensions with Iran. The Biden Administration wishes to avoid an energy shock in 2022 ahead of the midterm elections and may be willing to lift sanctions on Iran to that end. Iran may be willing to agree to the original deal to reduce sanctions, knowing that the deal begins to expire as early as 2025. However, the Iranian government does not have an incentive to halt progress on its nuclear and missile program, and it also fears another US change of ruling party in 2024-25. Therefore, any removal of US sanctions will be a temporary solution: It will boost oil supply in the short run but may not have a lasting impact as regional military threats to oil production will revive sooner than expected. However, Gertken thinks that the likelihood of a deal with Iran is less than 50/50. In that case, sanctions will stay in effect, Iran will achieve breakout uranium enrichment capacity, Israel will dial-up military threats, and the price of oil will see a rising risk premium, with higher odds of a major supply disruption. Russia invading Ukraine will also trigger sanctions and a cut-off of natural gas that flows through Ukraine to Europe, which will lead to a further supply squeeze and a potential shock that would weigh on European and global growth. In that case, from a geopolitical perspective, the Saudis and Americans will increase production to prevent demand destruction. Thus, the most likely outcome is heightened oil price volatility. However, in a way, this outcome is somewhat favorable to US producers as prices would be loosely anchored around the current level. This said, a key opposing geopolitical risk is a drastic move by OPEC, i.e., by the Saudis, who are capable of flooding the market with oil. This move would be aimed both at Iran and the US shale producers, to preempt loss of market share by lowering the price of oil and removing incentives for the other oil producers to ramp up production in response to growing global demand. The Saudis might do this if the US and Iran strike a new deal and the US is about to lift sanctions on Iran. The effect of such a potential move by OPEC will have a much more severe effect on the oil prices than if the US lifts sanctions on Iran. BCA’s Commodity & Energy Strategy argues that it is highly likely that OPEC 2.0 will increase output in response to strong global growth, but that the Saudis will not initiate a full-fledged market-share war as they did in 2014. Bottom Line The US Energy sector is in the early innings of the new Capex and production cycle. Strong and growing demand for oil and gas, and faltering supply from OPEC 2.0, exacerbated by the geopolitical tensions with Iran and Russia, put the US Energy sector into the driver’s seat to ramp up production and pick up slack in global supply.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     CFRA, Upstream & Downstream Energy Survey, January 2022. 2     https://www.eia.gov/outlooks/steo/ 3    Please see Key Themes for the Global Energy Economy in 2022 published by the Oxford Institute for Energy Studies on January 18, 2022. 4    Today, operators develop their acreage in a “manufacturing-style” process: First, 6-12 horizontal wells are drilled in succession on the same drilling pad, each well radiating out on a different path; then, after all the wells are drilled, the completion equipment is brought to the pad and the wells are fracked and put online in a similar assembly-line fashion. While this process is far more efficient in terms of both time and capital, allowing each active rig to drill more wells per year, it does mean that the average time lag between drilling a well and realizing production from that well takes six to eight months. 5    Federal Reserve Bank of Dallas, Survey of Executives of 122 oil and gas firms, December 8-16, 2021.   Recommended Allocation

Highlights A feedback loop has emerged in European markets. Tightening financial conditions will preempt the European Central Bank from hiking rates as much as the money market is pricing in. The widening in peripheral and credit spreads is overdone. Investors already long should maintain their positions. Investors without exposure will soon find an attractive entry point. Despite these near-term gyrations, the ECB is still on track to hike interest rates once in Q4 2022 and lift them aggressively in 2023. Feature Last week’s hawkish pivot by the European Central Bank (ECB) continues to affect markets. We take the words of the ECB at their face value; we anticipate the Governing Council (GC) to begin lifting interest rates at the end of 2022 and to continue to do so steadily over 2023 and 2024. However, as the shock filters through financial asset prices, we become more confident that the ECB will not lift rates five times in 2022 as the Euro Short Term Rate (ESTR) curve currently anticipates. Chart 1Growing Tensions In The Periphery... First, the behavior of Italian and Greek bond markets constitutes a major support to our view. Italian and Greek 10-year spreads have widened by respectively 46 and 65 basis points over the past six trading days (Chart 1). This tension highlights that investors still view these economies as continental trouble spots. Meanwhile, the ECB’s communication continues to highlight the need for flexibility to maintain order in the sovereign debt market. The GC does not want inadvertently to engineer a severe tightening in financial conditions in the already fragile periphery. In this context, it is highly unlikely that the ECB will rush to terminate the Asset Purchase Program (APP), an end on which rate hikes depend. Second, the corporate bond market is also going through a significant period of ruction. Both investment grade and high-yield bond yields have risen rapidly in recent days, and they are now retesting their late-2018 levels (Chart 2, top two panels). Spreads too are widening meaningfully, even though they remain further away from their 2018 highs (Chart 2, bottom two panels) The ECB is unwilling to let a liquidity shock morph into a solvency problem for European firms. For now, the behavior of the European credit market remains consistent with a liquidity shock. Funding markets are experiencing a violent adjustment, which is bleeding into the overall level of spreads. However, investors are not differentiating based on credit risk. Chart 3 shows that CCC credit (the lowest rated HY bonds) is not selling off relative to the overall high-yield index, which we would anticipate if investors were worried about underlying default risk. Chart 3No Distinction On Credit Risk Chart 2...And In European Corporates If the liquidity shock were to deepen further and last long enough, the resilience of the corporate sector would fritter away. However, the GC has tried to resist a deflationary shock for more than ten years now, and a solvency problem would undo all the progress made toward escaping the European liquidity trap, especially because wages have yet to recover. Third, members of the ECB’s GC are already trying to talk down the market. President Christine Lagarde displayed a more dovish tone when she spoke in front of the EU Parliament on February 7, 2022. ECB Chief Economist Philippe Lane remains steadfast that wages are not yet a problem. The Governor of the Bank of France, François Villeroy de Galhau still sees an imminent peak in CPI, and Olli Rehn, Governor of the Bank of Finland, recently lectured about the need for a gradual normalization of policy. Even hawks like the Bundesbank’s Joachim Nagel or the DNB’s Klaas Knot have gestured toward higher rates, but only toward the end of the year. In this context, we expect credit spreads to begin to narrow again; however, it will likely first require an easing in funding pressures. This is unlikely to happen until US yields form an interim peak. However, as Chart 4 highlights, the Treasury market is becoming extremely oversold. Moreover, a JP Morgan survey shows that its clients are massively short duration. The risk of a pullback in Treasury yields is growing, even if rising inflation and fears of a tighter Fed prevail for now. If US yields were to decline Bunds would likely follow the Treasury market because the ECB is becoming louder that it does not want to tighten financial conditions abruptly. Hence, a pullback in global risk-free yields will be the key to a period of calm in credit spreads, since valuations have improved materially, with the breakeven spreads on investment grade and high-yield bonds moving back to their 43rd and 44th percentiles, respectively (Chart 5). A stabilization in global yields and European spreads should also percolate to the peripheral sovereign bond market and limit the upside to Italian and Greek spreads. Chart 4Oversold Treasurys Chart 5Restoring Value In Corporates Bottom Line: The tightening in financial conditions taking place in Europe indicates that money market curves are pricing in the path for European policy rates too aggressively. The ECB has changed since 2011. It will not let peripheral borrowing costs threaten the recovery in Southern European economies, nor will it allow a liquidity shock in the corporate bond market to become a solvency issue that will damage growth prospects. European peripheral and corporate spreads will narrow once global risk-free rates peak.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Executive Summary The Euro And Relative Growth The euro is likely to appreciate over the course of 2022. But the path will be volatile, with a retest of recent EUR/USD lows within the central band of possible outcomes. Our 2022 target for the euro is 1.20. This partly hinges on cheap valuations. Beyond 2022, a bold estimate could see the euro gravitate towards 1.40. The pricing of interest rate hikes by the ECB this year are too aggressive. But this is also the case for the Federal Reserve, especially if inflation proves transitory. Our bias is that appreciation in the euro will be more driven by improving relative economic fundamentals as the 2022 cycle unfolds. A bottom in Chinese growth could be the ultimate arbiter of which mega economy outperforms. Sentiment on the euro is only neutral. This suggests that an escalation in Russo-Ukrainian tensions, as well as a more dovish ECB, are key risks in the short term. A short EUR/JPY position is a good hedge for this risk. In our FX portfolio, we are long EUR/CHF and long EUR/GBP as equally playable themes. We would buy the EUR/USD at current levels but suspect a better entry point awaits us. Recommendations Inception Level Inception Date Return Long EUR/CHF 1.05 2021-11-19 0.62% Long EUR/GBP 0.846 2021-10-15 -.71%   Bottom Line: A positive surprise in Chinese growth, which will boost the euro area trade balance, will be a catalyst for eurozone growth. So will a decline in Russo-Ukrainian tensions and lower energy inflation. Feature The most persistent question we have received in recent weeks is the outlook for the euro. As the premier anti-dollar asset, most clients have been surprised by recent strength in the European currency, betting that a hawkish Fed and US exceptionalism will push the greenback to new highs. A domestic energy crisis interlinked with a brewing war in their backyard has created perfect conditions for selling the euro. With US inflation surprising to the upside, the case for maintaining a dollar-bullish stance remains in place. Yet, the dollar is well below its previous highs. Our suspicion is that the market faces a conundrum. Transitory inflation will nudge the Fed to underwhelm market expectations of aggressive rate hikes. Meanwhile, sticky inflation means that other central banks will eventually catch up to the Federal Reserve in tightening monetary policy. This tug of war has been a defining theme of our strategy for currencies in 2022.1 Specific to the euro area, there is a lot of bad economic news that is now well priced in, while good news is underappreciated by markets. This is becoming evident in the interest rate market, where real Bund yields are creeping noticeably higher. The spread of Omicron in the euro area is receding in lockstep with the deceleration in the US (Chart 1). As a result, the potential growth profile of the euro area is improving tremendously (Chart 2). Should this prove durable, it will put a solid floor under the euro. Chart 1The Pandemic Is Receding Chart 2The Euro And Relative Growth The Case For European Growth Growth is moderating around the world. That said, the German manufacturing PMI has been sharply outpacing that of the US. What is also true is that most measures of euro area growth that we monitor are rising fast relative to the US. The results are preliminary, but the possibility of a growth rotation from the US to other economies, including the eurozone, is very much underappreciated by markets. The economic surprise index in the euro area is strong relative to the US, pointing to a stronger euro (Chart 3). Bloomberg economic forecasts suggest that euro area growth will outpace growth in the US this year. According to the consensus, the euro area will grow by 4.2% in 2022, compared to the US at 3.9%. Remarkably, eurozone growth has typically lagged growth in the US by a significant margin. If past is prologue, it suggests the euro is not priced for this paradigm change (Chart 4). Chart 3Economic Surprises And ##br##The Euro Chart 4Bloomberg Forecasters Expect A Pickup In Eurozone Growth Other economic forecasts corroborate this view. The IMF expects eurozone growth to moderate from 5.2%, to 3.9% in 2022. This is an advantage over the US, where growth is expected to moderate from 5.6% in 2021, to 4% in 2022. The Atlanta Fed GDP growth tracker suggests US growth will slow to a crawl in Q1. The ZEW survey points to a meaningful rebound in the German (and euro area) PMI in the coming months (Chart 5). This will further widen the gap between European and US growth. The key denominator for all these forecasts is a bottoming in Chinese growth. The euro area needs the manufacturing and external sector to keep humming, with China as a critical import partner. Industrial production in the euro area, relative to the US, tends to track the Chinese credit impulse closely (Chart 6). Our bias is that the Chinese credit impulse has bottomed. This will be a catalyst for more Chinese demand for European goods. Chart 5The ZEW Survey Points To An Improving German PMI Chart 6Europe Is Partly Dependent On China The ECB And Interest Rates Chart 7The Gap Between Expected US-EUR Interest Rates Is Wide The markets have begun to reprice higher interest rates in the eurozone. Admittedly, this has been partly due to higher expected inflation. In our view, the repricing by markets is warranted due to the gaping wedge between US versus European interest rate expectations. According to December 2022 contracts, markets expect the Fed to hike interest rates by significantly more than the ECB (Chart 7). It is true that structurally, inflation in the eurozone has been lower than in the US. In fact, our European Investment Strategy colleagues highlight that by stripping out energy, and the impact of VAT tax increases, European inflation is even lower. When CPI baskets are adjusted item for item, eurozone inflation today is indeed lower compared to the US, but not by much (Chart 8). For example, energy and transportation are only 14% of the eurozone CPI basket versus 26% in the US (Table 1). Meanwhile, the ECB targets HICP inflation (not core) that sits at 5.1%, versus a target of 2%.  Chart 8Item-For-Item Inflation: US Versus Eurozone Table 1Differences In The US And Eurozone CPI Basket In the coming months, inflation is likely to subside in the eurozone, but probably by less than markets expect. The key driver of inflation expectations in the eurozone (and in the US) are long-dated commodity prices (Chart 9). This has become even more evident, given the surge in electricity prices across many European countries. Robert Ryan, our Chief Commodity Strategist, expects long-dated crude prices to be revised upward, as the oil curve remains persistently backwardated. This puts a floor on how low inflation expectations can relapse in the euro area and will keep the ECB on edge. Meanwhile, the employment picture in the eurozone is also improving. Adjusting for the higher rate of structural unemployment, euro area joblessness compares favorably with the US (Chart 10). It is true that wage growth remains anemic, but it is also the case that the behavior of wages can exhibit a structural shift at very low levels of employment.  Chart 9What Drives Eurozone Inflation Expectations? Chart 10US Versus Eurozone Labor Markets Finally, the euro zone has a lot of pent-up demand. This could help bolster growth in the coming quarters and even beyond. While not a subject of this report, we suspect that the cascading crises in the eurozone could have sown the seeds for a productivity boom in the coming years. For a 12-18-month outlook, high savings and easy fiscal policy will allow European growth to recover in the coming quarters. EUR/USD Valuation And Future Returns Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 4%-5% a year over the next decade, should the euro stay at current levels of undervaluation versus the US. This will occur if Eurozone inflation keeps lagging that in the US.  (Chart 11). That said, this is the Goldilocks case. A simple return to PPP fair value will suggest the euro will rise by a robust 20%. For 2022, our forecast for the euro is more in the 1.20-1.23 range, 8% above current levels. Our stance is measured because investors are only neutral the euro (Chart 12). Usually, this means that the macroeconomic environment becomes the dominant driver, rather than sentiment. With a Russo-Ukrainian crisis still in the backyard and the potential for more market volatility, an undershoot in the euro cannot be ruled out.  Chart 11The Goldilocks Case For The Euro Chart 12Sentiment On The Euro Is Only Neutral That said, interest rate differentials are now moving in favor of the euro. Italian BTPs now yield 1.9%, like US Treasurys. The US Treasury-Bund spread has also narrowed. This removes a lot of the incentive for Europeans to flood the US Treasury or TIPs market, should market volatility subside. Given this confluence of factors, we have chosen to play euro strength via two channels: Long EUR/CHF: This trade will benefit from positive interest rate differentials. Also, the Swiss franc has been bid up relative to the euro on safe-haven demand. This has outpaced the traditional demand for safety, using the DXY index as a proxy (Chart 13). Long EUR/GBP: This is a bet on improving economic fundamentals between the eurozone and the UK (Chart 14), as well as a bet on policy convergence between the two economies. Chart 13Stay Long EUR/CHF Chart 14Stay Long EUR/GBP   Footnotes 1 Please see Foreign Exchange Strategy Report, “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant”, dated January 14, 2022.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

  Executive Summary Inflation Expectations Likely Too Low Inverted term structures for industrial commodities likely are being interpreted as forecasts of lower prices. This leads investors to assume the real economy will not be a source of persistent inflationary pressure. This is misguided: Backwardations (i.e., inverted forward curves) are evidence of tight markets facing severe upside price pressures, not lower prices ahead. Oil and base metals prices share a stronger relationship with US 5-year/5-year inflation expectations than gold, which is more correlated with short-term inflation expectations. Increases in US permanent unemployment are positively correlated with 5y5y inflation expectations. This suggests markets price in a more accommodative Fed as permanent unemployment increases, and vice versa. US PCEPI realized core inflation is negatively correlated with permanent unemployment levels, suggesting markets are pricing lower inflation as permanent unemployment rises, and vice versa. Bottom Line: Markets generally exhibit well-anchored inflation expectations. We believe these will be undone by profound backwardations in industrial commodities, which point to steadily increasing inflation pressures from the real economy to end-2023. Thereafter, oil and metals demand will continue to grow faster than supply, as the renewable-energy transition picks up steam. We remain long commodity-index exposure, and industrial-commodity producers' equity via ETFs. Feature Backwardated forward curves for industrial commodities – oil and base metals, in particular – are clear evidence these markets are pricing to severe physical supply deficits, which presently are being covered by drawing down inventories.1 These inverted term structures for industrial commodities likely are being interpreted as forecasts of lower prices, which leads investors to assume the real economy will not be a source of more permanent inflationary pressure. This is misguided, in our view: Profound inversions in the term structure of commodities (i.e., backwardations) are evidence of tight markets facing severe upside price pressures. Persistently tight supply-demand balances are keeping the forward curves of industrial commodities backwardated, as inventories are drawn down to cover physical supply deficits. These deficits are dramatically evident in oil markets (Chart 1) and copper markets (Chart 2), both of which are widely followed by investors and corporates alike. Chart 1Tight Oil Markets Chart 2Coppers Physical Deficits Will Persist...   Higher Commodity Prices, Higher Inflation In Chart 3, we show the difference between the forecast outcome of US 5-year/5-year (US5y5y) CPI inflation expectations drawn from the CPI swap markets as a function of our internal oil-price forecasts and commodity forwards reflecting futures-contract settlements. These curves show the model based on the futures curve understates the expected path of inflation expectations versus our oil-price forecasts. When we used our higher oil price forecasts – based on the scenario where OPEC 2.0 and the US fail to increase oil supply in 2022 and 2023 – US5y5y rates tracked the increase in oil prices. The results of these forecasts show that oil prices, and more broadly, the real economy, feeds directly  into inflation expectations. We modelled the US5y5y rates as a function of additional commodity prices as well – namely, copper and gold (Chart 4). The coefficients for commodity prices associated with the levels equation was always positive, irrespective of the commodity, implying that commodity prices and inflation expectations share a long-run equilibrium. We ran these regressions with nearer term forward inflation expectation rates as well, and found the direction of the relationship held.2 Chart 3Inflation Expectations Likely Too Low Chart 4Consistent Relationships Between Commodities and Inflation Expectations Gold Hedges Shorter-Term Inflation Expectations Gold prices had a stronger relationship to nearer-term forward inflation expectation rates than WTI and COMEX copper prices, in our modeling. On the other hand, WTI and COMEX copper prices had stronger relationships with longer-term forward inflation expectation rates than gold prices. These results suggest different commodities can be used to hedge different segments of the inflation-expectations term structure, which is a novel outcome to our modeling. This strongly suggests a portfolio of gold, copper and crude oil – using futures, commodity indices or physical assets – can hedge the inflation-expectations term structure. Labor Markets And Inflation Expectations We also modelled realized monthly inflation and US5y5y inflation expectations as a function of permanent job losses, a series maintained by the US Bureau of Labor Statistics (BLS).  The coefficient associated with permanent job losses was positive (Chart 5). Increases in US permanent job losses are positively correlated with 5y5y inflation expectations. This suggests markets price in a more accommodative Fed in the future as permanent unemployment increases, and vice versa. This positive relationship holds even when WTI and copper prices are added as regressors to the equation. We also find that realized US PCEPI core inflation – the Fed's preferred gauge – is negatively correlated with permanent unemployment levels, suggesting markets are pricing lower inflation as permanent job losses increase (Chart 6). This also is intuitively appealing in the model, as it points toward the markets' assessments of Fed policy functions. Chart 5Labor Markets Also Effect Inflation Expectations Chart 6Lower Inflation When Permanent Job Losses Rises Investment Implications In earlier research, we showed commodity prices generally feed directly into realized inflation and inflation expectations (Chart 7).3 In the current report, we also showed that different commodities are better suited for hedging inflation expectations at different points along the inflation forward curve, which is a novel finding. We continue to expect the global energy transition to keep industrial commodities well bid for at least the next decade, as markets are forced to reconcile increasing demand for hydrocarbons and base metals with flat to declining supplies. On top of this, as we have noted in the past, there is a growing list of exogenous threats to the supply side. Among them are the election of left-of-center governments in important commodity-producing states, which have campaigned on redistributionist agendas; climate activism at the board level at major energy suppliers and in the courtroom, and mounting calls for still-undefined ESG compliance. Chart 7Commodity Indices Move Closely With Inflation Expectations All of these threats – not to mention increasing geopolitical threats globally – add uncertainty to the evolution of commodity markets and increase the costs of producing commodities. As supply curves become more inelastic, higher prices for these commodities will be required to allocate capital and ration demand. We remain long commodity-index exposure, and industrial-commodity producers' equity via ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US liquified natural gas (LNG) exports surged to an average of 11.2 Bcf/d last month, an 8% increase from the 10.4 Bcf/d shipped ex-US in 4Q21, according to the US EIA. Continued strength in Asia and Europe were responsible for the increase. The EIA cited the low level of European inventories for the sharp move higher. We have been expecting European demand to remain strong coming out of winter, as inventories are rebuilt (Chart 8). Exports are expected to average 11.3 Bcf/d this year, or 16% above 2021 levels. Base Metals: Bullish LME aluminum prices hit their highest since 2008, on the back of low inventory levels and supply disruptions (Chart 9). Industrial metals generally are facing tight markets, with nickel hitting a decade high earlier this year. Towards the end of last year, Zinc prices started rising and are now closing in on the decade high seen in October 2021. Low inventories of these metals in different parts of the world are backwardating forward curves and causing prices to rise. For example, according to data from World Bureau of Metal Statistics, Zinc LME stocks were only at 1,650 tons in December in Europe. Reduced supply and refining activity in Europe and China, have contributed to these markets’ tightness. In Europe, high power prices have caused smelters to stop production, while in China, refining activity has fallen due to the country’s zero-COVID tolerance policy.   Precious Metals: Bullish According to the Australian Department of Industry, Science, Energy and Resources, the semiconductor chip shortage is expected to result in 7.7 million fewer vehicles being made in 2021. According to data from SFA Oxford via Heraeus, in 2021, automotive demand is forecast to constitute 80% of total palladium demand. The underperforming automotive sector, which makes up a significant chunk of palladium demand, led to Palladium being one of the worst performing commodities in 2021. The chip shortage will persist into 2022, pressuring automotive demand for platinum and palladium. Weak auto production will affect platinum to a lesser extent, since demand from automotive manufacturing constitutes just ~30% of total demand. Recently, however, palladium prices rose on geopolitical uncertainty arising from the escalating Russia-Ukraine conflict. Russia constitutes ~ 43% of global palladium production. Chart 8 Chart 9     Footnotes 1     Chart on p. 1 (Chart 3 below) shows the impact the backwardation in crude oil has on forecasted US 5-year/5-year inflation expectations in Model Output 2. The backwardation in Model Output 3 lowers the US5y5y estimate, while our forecast for higher prices raises the inflation expectation. We have written at length on this topic, most recently in our reports of on January 27, 2022, Short Squeezes In Copper, Nickel Highlight Tight Metals Markets, on January 6, 2022, Persistent Inflation Pressures From Commodities and on November 4, 2021, in a report entitled Despite Weaker Prices Crude Oil Backwardation Will Persist. These reports are available at ces.bcaresearch.com. 2     COMEX copper and WTI oil futures are stronger regressors in explaining US5y5y – i.e., their shared long-term trend (i.e., cointegration) is stronger (statistically speaking) than gold futures. This is particularly evident in the regressions of US5y5y employing realized CPI monthly inflation and US real exchange rates as additional explanatory variables in the equations using the industrial-commodity prices. It is worthwhile noting that the 3-year forward WTI futures contract as a lone regressor for US5y5y inflation expectations continues to produce some of the strongest results in our modelling exercise. Indeed, as a sole regressor, it dominates the other models. 3    Please see More Commodity-Led Inflation On The Way and Persistent Inflation Pressures From Commodities published on December 9, 2021 and on January 6, 2022, respectively.  Both are available at ces.bcaresearch.com.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021

Executive Summary Rising TIPS Yields = Equity Multiples Compression Equity sector and style rotations could prevent the broad equity indexes from plunging, but these rotations will not be sufficient to propel the overall stock indexes to new highs. Rising US bond yields remain the key risk to US growth stocks in both absolute and relative terms. As US growth stocks drift lower in absolute terms, the S&P 500 will stay in a trading range but is unlikely to make new highs. Equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Recommendation   Inception Date Return Underweight EM Relative To DM Stocks (In Common Currency) 2021-03-25 15.8% Bottom Line: Continue underweighting EM in a global equity portfolio. Cyclically, continue favoring value versus growth stocks. Feature We expect US bond yields to continue to rise, and global growth stocks to continue to underperform global value stocks in the months ahead. This prompts the question: What does this scenario mean for overall global share prices, EM markets, and EM relative equity performance? Equity Rotation And Overall Market Performance Can the S&P 500 or global equity index advance in absolute terms when US and global growth stocks sell off in absolute terms? Our hunch is as follows: As US growth stocks drift lower, the S&P 500 will stay in a trading range, but is unlikely to make new highs. A review of past episodes of sector and style rotation is in order. We recall two episodes of major rotation: 1. The closest historical comparison is in the year 2000. The top panel of Chart 1 illustrates US value stocks were resilient even after the Nasdaq bubble started bursting in March 2000. Besides, the S&P 500 index held up well in the first half of that year even though Nasdaq stocks were plummeting (Chart 1, bottom panel). Nevertheless, despite the rotation, value/old economy stocks failed to break out of their previous highs (Chart 1, top panel). We would expect a similar pattern to emerge in the current cycle as the Nasdaq index wobbles. Despite the Nasdaq selloff, oil prices continued to rise until October 2000, and the US median stock had a bumpy ride but made a new high in early 2002 (Chart 2). Chart 1US Equity Rotation In 2000 Chart 2Rotation In 2000: The Nasdaq, Oil And The Median Stock   Overall, as rising US interest rates weigh on growth stocks, the rest of the market can stay in a trading range. Segments with very good fundamentals and cheap valuations could even make new marginal highs. Nevertheless, given the sheer weight of growth stocks in the broad US equity index, it will be hard for the S&P 500 to make new highs when growth stocks wobble. However, a key difference between now and the 2000-2002 market is that back then, US bond yields were falling. Thus, the bear market in the US equity market in general and Nasdaq stocks in particular, occurred alongside falling US bond yields (Chart 3). Currently, the Fed is in a tightening mode and US bond yields are climbing. A rising discount factor is negative for all stocks (Chart 4): It is more negative for high-multiples stocks and less negative for low multiples companies. Chart 3The Nasdaq Bubble Burst Despite Falling Interest Rates Chart 4Rising TIPS Yields = Equity Multiples Compression   Another interesting observation about the 2000-2002 bear market is that it occurred despite resilient US consumer spending, and a very robust housing market and credit growth (Chart 5, top two panels). Remarkably, corporate profits collapsed by about 60% even though real GDP barely contracted at all (Chart 5, bottom two panel). We do not predict a similar equity bust this time around. Instead, we are highlighting that US equity valuations and corporate profits can shrink even if US consumer spending does not contract. What happens to costs, profit margins, inflation and interest rates are as important as the consumer spending outlook. To sum up, when the Nasdaq’s bubble began bursting in March of 2000, investors rotated into old economy stocks and the S&P 500 held up well until July of that year. From July onward, the selloff broadened, and the overall US equity indexes entered a bear market. The latter lasted until March 2003. 2. Another episode of extended market rotation occurred in the lead up to and during the 2008 bear market. The US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 6). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 6, bottom panel). Chart 5US Profits Recession In 2001 Occurred Despite No Economic Recession Chart 6Domino Effect In 2007-08 Clearly, what was initially a rotation out of US cyclicals and financials into commodities and EM eventually proved to be nothing more than part of a domino effect. Again, we are not making the case that the US economy and financial markets are headed into a financial crisis. Our point here is that rotations do occur and can last for a while. Yet, a sustainable bull market in aggregate equity indexes does not emerge until there is a broad-based selloff during which the majority of sectors and bourses drop in absolute terms. Bottom Line: Rotation episodes can last several months. Equity sector and style rotations could prevent the broad equity indexes from plunging but these rotations will not be sufficient to propel the overall stock indexes to new highs. Equity Leadership Changes Occur Around Major Selloffs Having examined these rotation episodes, we can now take a step back and see the big picture: equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Chart 7 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM, and all of them coincided with, or were preceded by, either a bear market or a substantial drawdown in global share prices. Chart 7EM Versus DM: Equity Rotations Similarly, the relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs (Chart 8). Chart 8Global Growth Versus Value: Leadership Rotations Finally, secular trend changes in the relative performance of the global tech sector, energy stocks and materials have also occurred during or after drawdowns in global share prices (Chart 9). Chart 9Global Technology, Energy And Materials: Leadership Rotations A word on commodity prices is warranted. We are surprised that industrial metal prices have so far held up well and oil prices have been surging despite China’s slowdown. The culprits behind the rally in resource prices are strong DM demand for commodities and investor purchases of commodities as an inflation hedge. Therefore, it might take investor concerns about US demand and/or a slowdown in global manufacturing to trigger a relapse in commodity prices. Rising US interest rates and a continued US dollar rally will eventually lead to a meaningful drawdown in commodity prices. Yet, the precise timing of this shift is uncertain. Critically, among financial markets, oil prices are often the last to fall and/or rally. Hence, investors should not use oil as a leading indicator for other markets. As to share prices of commodity producers, global materials have rolled over at their previous high (Chart 10, top panel), while energy stocks have surged through multiple technical resistances. However, they now face another technical hurdle (Chart 10, bottom panel). If oil share prices decisively break above this long-term moving average, it would likely signal that they have entered a multi-year bull market. Chart 10Global Energy Stocks And Materials: A Long-Term Profile Bottom Line: Major equity leadership rotations normally occur around bear markets or major corrections. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Investment Considerations Chart 11EM And US Stocks Relative To The Global Benchmark: No Change In Trend We will contemplate upgrading EM if a broad selloff transpires. In such an equity drawdown, there is a 50% chance that EM may outperform the S&P 500 if the selloff is led by growth stocks, as occurred during the carnage in global stocks in January this year or in the fourth quarter of 2018 (Chart 11, top panel). Yet, the EM overall equity index will underperform Europe and Japan in such a broad-based drawdown. A weaker dollar is essential for EM outperformance. For now, we remain positive on the dollar for the next several months and are hence underweight EM stocks and credit markets versus their DM peers. As to US stocks, the jury is still out on whether their secular outperformance is over. Notably, US share prices relative to the global equity index have rebounded from their 200-day moving average (Chart 11, bottom panel). When such a technical pattern occurs, odds are high that US stocks will make new highs in relative terms. US equities outperforming the rest of the world is not consistent with growth stocks underperforming value ones. Hence, a potential US outperformance represents a risk to our core view that growth stocks will continue underperforming value stocks. How do we reconcile these inconsistencies? It might be that US growth stocks’ recent rebound persists for the next several weeks and they outperform value stocks during this window. In such a case, our equity leadership rotation theme will be delayed. Yet, in this scenario EM stocks will continue underperforming DM ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations