Economy

Highlights Spread Product: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market & Fed: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. The Treasury curve will bear-flatten as that outcome is priced in. Duration: Investors should maintain below-benchmark portfolio duration with an expectation that the 10-year Treasury yield will reach a range of 2%-2.25% by the time of Fed liftoff in December 2022. Feature Chart 1A December Debt Ceiling Debate The creditors of the United States government can breathe a little easier, at least for a couple of months, as Congress reached an agreement last week to punt debt ceiling negotiations until December. T-bills maturing this month reacted sharply to price-out the risk of technical default, though December bill yields have already started to push higher in anticipation of more turmoil (Chart 1). Of course, the political incentives to lift the debt ceiling will be the same in December as they are today, and Congress will ultimately act to avert economic disaster.1 Financial markets seem to realize this, and Treasury note and bond yields have been unphased by the drama. Instead, Treasury yields have moved higher in recent weeks alongside other indicators of optimism surrounding economic reflation and re-opening (Chart 2). However, there is one troubling signal from financial markets that warrants further investigation. Corporate bonds (both investment grade and high-yield) have underperformed duration-matched Treasuries so far in October, even as Treasury yields have moved higher (Chart 3). Typically, Treasury yields and corporate bond spreads are negatively correlated – spreads tighten as Treasury yields rise, and vice-versa – so it is notable when the correlation flips. Chart 2The Reflation Trade Is Back Chart 3Bad Times For Bonds   The next section of this report explores the economic drivers of the yield/spread correlation and considers whether the flip to a positive yield/spread correlation signals anything about future corporate bond performance. An Examination Of The Yield/Spread Correlation The simple economic explanation for the negative yield/spread correlation is that an improved economic outlook leads to both a better environment for credit risk (i.e. tighter corporate bond spreads) and the expectation that higher interest rates will be needed to cool the economy in the future (i.e. higher Treasury yields). With that in mind, when spreads and yields both rise at the same time it usually means that the Fed is “over-tightening”. That is, tightening monetary policy so much that the near-term credit environment is deteriorating. This could be because the Fed is making a policy mistake – tightening into an economic slowdown – or because inflation is high enough that the Fed is deliberately slowing growth in an effort to bring down prices. A Technical Examination Looking at the history of monthly changes in Treasury index yields and High-Yield index spreads since 1994, we see that it is quite unusual for yields and spreads to both rise in the same month (Chart 4). In fact, monthly yield and spread changes are negatively correlated 65% of the time and have only risen together in 15% of the months since 1994. Chart 4Monthly Junk Spread Changes Versus Monthly Treasury Yield Changes Since 1994 Second, we observe in Chart 4 that almost all months of large spread widening or tightening occur against the back-drop of a negative yield/spread correlation. This shouldn’t be too surprising. The worst months for corporate bond performance occur during economic recessions when the Fed is cutting interest rates. Conversely, the best months for corporate bond performance occur just after the recession-peak in spreads when the Fed has finished cutting rates and the economic recovery is starting up. Tables 1A and 1B delve deeper into the return numbers. Table 1A shows average High-Yield excess returns over different investment horizons following a signal from the yield/spread correlation. For example, the second row shows that after a month when both Treasury yields and junk spreads rise, high-yield bonds deliver average excess returns of 24 bps during the following 3 months, 116 bps during the following 6 months and 75 bps during the following 12 months. Table 1B provides even more detail by showing 90% confidence intervals for each number. Table 1AAverage High-Yield Excess Returns After A Signal From Yield/Spread Correlation Table 1BHigh-Yield Excess Returns After A Signal From Yield/Spread Correlation: 90% Confidence Intervals We draw two conclusions from this analysis. First, a month when spreads widen and yields fall sends the worst signal for near-term (3-month) corporate bond performance, though a month where both yields and spreads rise is a close second. Second, and most relevant for the current market, a month when yields and spreads rise together sends the worst signal for junk bond performance over the following 12 months. In fact, it is the only signal where the 90% confidence interval shows the chance of negative excess returns during the following 12 months. This second conclusion aligns with our intuition. A period of both rising Treasury yields and junk spreads likely signals that the market is pricing-in some move toward a tighter monetary policy stance, though not a severe enough move to send long-maturity Treasury yields down. This is most likely to occur in the very early stages of a monetary tightening cycle, when monetary conditions are still accommodative but recent shifts in Fed policy suggest that they will become more restrictive down the road. A Historical Examination A look back through history confirms our analysis of when yields and spreads tend to rise concurrently. The solid line in the third panel of Chart 5 shows the number of months when both junk spreads and Treasury yields rose out of the most recent trailing 12-month period. The dashed line shows the same measure over the trailing 3-month period, multiplied by 4 to put it on the same scale as the solid line. A spike in these lines indicates that Treasury yields and junk spreads were rising at the same time. Chart 5Rising Yields And Spreads Is A Warning Signal For Monetary Tightening We identify four relevant historical periods. First, yields and spreads rose concurrently during the 1999/2000 Fed tightening cycle. Specifically, yields and spreads rose together in the early stages of the tightening cycle, then spreads continued to widen as yields fell during the 2001 recession. Second, our indicator showed a couple blips higher during the 2004/06 tightening cycle, though corporate bond returns were solid during this period, at least until after the tightening cycle ended and the recession began. Third, the 2013 taper tantrum coincided with a temporary increase in both yields and spreads as investors worried that the Fed was moving too quickly toward rate hikes. Fourth, yields and spreads both moved higher in 2015 as the Fed was heading toward a December 2015 rate hike against a back-drop of slowing economic growth. Turning to today, we view the recent jump in our indicator as similar to the jump seen during the 2013 taper tantrum. Not only is the Fed once again about to taper asset purchases, but the tapering of asset purchases suggests that the Fed’s next move will be a rate hike at some point down the road. We view this as an early warning sign for corporate bond spreads. While the monetary environment remains supportive for positive corporate bond returns for now, this may not be true by this time next year when the Fed is that much closer to liftoff. Bottom Line: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market Update: Still On Track For November Taper And December 2022 Liftoff Chart 6Employment Growth Slowed in September September’s employment report delivered a disappointing headline number, with nonfarm payrolls growing only 194 thousand on the month compared to a consensus estimate of 500k (Chart 6). The details of the report were slightly better: August’s nonfarm payroll growth number was revised higher, our measure of the unemployment rate adjusted for distortions in the number of people employed but absent from work fell from 5.5% to 4.9% (Chart A1) and average hourly earnings rose at an annualized monthly rate of 7.7% (Chart 6, bottom panel). Expect A November Taper For bond investors, the most pressing question is whether the report is bad enough to delay the Fed’s tapering announcement past November. We doubt it. The Fed’s test for when to taper asset purchases, that it gave itself last December, is “substantial further progress” back to pre-COVID levels of employment. Since December 2020, total nonfarm payroll employment is 50% of the way back to its February 2020 level (Chart 7) and there are several good reasons to believe that employment growth will be much stronger in October and November. First, the delta wave of COVID cases clearly weighed on employment growth in September, much like it did in August. The Leisure & Hospitality sector only added 74 thousand jobs in September, compared to an average monthly pace of 349 thousand jobs between February and July of this year before the delta wave struck. With a shortfall of almost 1.6 million Leisure & Hospitality jobs compared to pre-COVID levels (Table 2), job growth in this sector will bounce back sharply during the next few months now that new COVID cases are receding (Chart 8). Chart 7"Substantial Further Progress" Has Been Made Chart 8Delta Wave Has Crested   Second, the last column of Table 2 shows that the government sector accounted for net job loss of 123 thousand in September. This negative number was driven by state & local government education jobs and is almost certainly a statistical artifact. According to the Bureau of Labor Statistics’ release notes: Recent employment changes [in state & local government education] are challenging to interpret, as pandemic-related staffing fluctuations in public and private education have distorted the normal seasonal hiring and layoff patterns. Table 2Employment By Industry Expect December 2022 Liftoff As for what this labor market report means for when the Fed will start lifting rates, we believe that we are still on track for liftoff in December 2022. The Appendix to this report updates our scenarios that show the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and labor force participation rates by specific future dates. If we use the median assumption from the New York Fed’s Survey of Market Participants that the Fed will lift rates when the unemployment rate is 3.5% and the participation rate is 63%, we calculate that average monthly nonfarm payroll growth of +453k is required to reach those targets by the end of 2022. We see that threshold as eminently achievable.2 Bottom Line: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. Investors should maintain below-benchmark portfolio duration and hold Treasury curve flatteners in anticipation of that outcome. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +453k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Footnotes 1 For more details on the politics of the debt ceiling please see US Political Strategy Weekly Report, “The House Ways And Means Tax Plan”, dated September 15, 2021. 2 For a discussion about what unemployment and participation rate targets to use in this analysis please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights In this report, we take a close look at corporate margins by analyzing their key drivers: The general level of economic activity, trends in labor costs and productivity, borrowing costs, tax rates, depreciation charges, the exchange rate, and corporate pricing power. The likely contraction of margins next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth and a decline in corporate pricing power.  In the meantime, the tight labor market is putting upward pressure on wage growth despite a peak in productivity improvement. Input costs are also on the rise with PPI soaring, cutting into corporate profitability. Depreciation is already rising on the back of the recent recovery in capex. Interest expense has bottomed in the face of rising rates, and the potential healing of corporate balance sheets is leading to re-leveraging to raise capital for capex and buybacks.  The US corporate tax rate is bound to increase based on news from Capitol Hill.   The model above encapsulates all of these moving parts (Chart 1) and reiterates that the path of least resistance is lower for US corporate margins. S&P 500 operating margins are likely to contract in 2022. Feature Profits Have Rebounded S&P 500 earnings growth has rebounded vigorously from the pandemic low. Operating earnings-per-share stand 32% YoY above the January 2020 pre-pandemic high (Chart 2). Margins have also exceeded pre-pandemic levels of 11.7% reaching 14.4% in September (Chart 3). The basic story behind a rebound in profitability is well understood: Companies have cut costs aggressively, productivity has improved, lower interest rates have reduced debt servicing burdens, a weaker dollar has boosted overseas earnings, and corporate pricing power has strengthened. Gauging the direction of change for each of these various factors will help us assess whether profits can continue growing, and whether operating margins can continue expanding. Chart 1After An Impressive Surge, Margins Are Set To Decline Chart 2Profits Have Rebounded Vigorously Chart 3Margins Are Above Pre-pandemic High Sneak Preview: We expect profit margins to contract in 2022 NIPA Operating Margins vs S&P 500 Operating Margins The market tends to focus on S&P 500 earnings and these can be measured on a reported or operating basis, with the latter removing the effects of one-off charges. In order to better understand the path of S&P 500 margins, we aim to relate profits to the economic cycle; to do so, we analyze the data from the national income and product accounts (NIPA) because they are fully integrated with GDP and any related series. National non-financial after-tax profits without the inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj)1 are conceptually closest to S&P 500 profits as they measure the after-tax worldwide earnings of US corporations. Fortunately, the S&P and equivalent national income measures of operating profits broadly track each other over the long run, although the S&P data display greater volatility. The NIPA profit margin series is 70% correlated with S&P 500 operating profit margins. While this level of correlation indicates that long-term trends in NIPA profits and S&P earnings are broadly similar, short-term annual and quarterly growth rates can differ dramatically. The Key Drivers Of Profitability A number of factors can influence the path of profits: The general level of economic activity, including trends in borrowing costs, tax rates, depreciation charges, the exchange rate, productivity, and corporate pricing power. It clearly would be most bullish if productivity had been the main driver because any future benefits from the other four sources will be limited. Interest rates will normalize at some point, and effective tax rates seem more likely to rise than fall from current levels, and we should hope for faster depreciation in line with increased capital spending. In addition, the downside in the dollar is constrained by the desire of other countries to maintain competitive exchange rates. Corporate pricing power is the sole mitigating factor against these cost pressures. In this report, we will methodically go through and assess the outlook for each of these profit drivers, and their cumulative effect on profit margins for the next year or so. Revenue Growth Is A Key To Margin Expansion The EBITD measure of domestic non-financial profits excludes the impact of changes in taxes, interest rates and depreciation charges and is thus the series that is most directly affected by the underlying economic cycle and by productivity. Moreover, because it covers only domestic profits, it is not overly influenced by exchange-rate movements. GDP growth and NIPA EBITD margin expansion move in tandem. The post-pandemic rebound in economic growth has underpinned margin recovery (Chart 4). However, real GDP forecasts have recently been cut from 6.5%  to just under 6% for 2021, and to 4% in 2022 (Chart 5). Slower growth suggests that the pace of margin expansion will also slow. Chart 4EBITD Margins Usually Track GDP Chart 5GDP Growth Is Expected To Slow Cost Drivers Of Profits Labor Expense As Percentage Of Sales Has Been Falling Looking at the expense side of the NIPA Income Statement, we note that labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items (Chart 6). The NIPA EBITD margin allows us to gauge the effect of changes in labor costs on the bottom line.  Chart 6Labor Costs Are The Largest Expense After the initial spike to 54% of sales at the beginning of the pandemic, explained by rapidly falling sales and an inability of companies to rapidly reduce employee numbers, labor costs as a percentage of sales have been reverting to historical levels.  This is a curious phenomenon as wages have recently been on the rise: The number of open positions has been exceeding the number of job seekers by over a million, indicating that jobs are plentiful.  As a result, the quit rate has exploded (Chart 7). To attract and retain workers, businesses have been raising compensation, leading to average weekly earnings rising by more than 5% year over year. As a result, wages-to-sales have been trending up (Chart 8). Chart 7Quit Rate Exploded Pushing Wages Up Chart 8Wages-to-Sales Have Been Trending Up If companies must pay more for labor, why has the labor expense as percentage of sales fallen? To answer this question, we will look at the selling prices over unit labor costs as a proxy for the EBITD margin (Chart 9) to examine the underlying profitability as a function of labor costs. However, since the beginning of the pandemic, this stable relationship has broken down, with selling prices falling over unit labor costs, while margins have been expanding. Digging deeper, we notice that NIPA sales prices have rebounded (Chart 10) due to a surge in inflation and a rise in a corporate pricing power (Chart 11), while unit labor costs dived. This can be attributed to a pandemic productivity surge (Chart 12), making it cheaper to produce each additional unit.  Chart 9A Proxy For EBITD Margin Chart 10Sales Prices Are Up, Unit Labor Costs Are Down Chart 11US Corporate Power Is Waning Chart 12Productivity Has Peaked However, after rising for months, the ability of companies to raise prices further has been diminished by consumers’ income increasing slower than inflation, reducing their purchasing power.  Improvements in productivity have also peaked and are unlikely to propel margins higher.  Input Costs Are Soaring While cost of goods sold (COGS) is not one of the lines in the NIPA income statement, we would be remiss not to mention that input costs have been on the rise. The most recent reading in PPI was up 8.3% YoY (Chart 13). The price of oil has been surging as well. An increase in the cost of materials definitely has an adverse effect on corporate margins. We will quantify the effects of the year-on-year percentage of PPI on margins later in this report. Chart 13Input Prices Have Soared Other Drivers Of Profitability: Depreciation, Interest And Taxes Switching gears to other costs, interest, taxes, and depreciation expenses are likely to increase going forward. Capex Is Rising, So Will Depreciation Expense Depreciation expense is the second largest expense in the cost structure, constituting some 15% of sales. Between mid-2009 and mid-2012, depreciation charges fell sharply, curtailed by weak investment growth during the Global Financial Crisis (GFC) economic downturn. Similarly, the same story unfolded during the 2015 manufacturing slowdown, and the pandemic-induced recession (Chart 14). Today, growth in US domestic fixed investment has rebounded at rates comparable to the 2000 and 2010 recoveries. The trend will continue: According to the Philly Fed Manufacturing Survey, capex intentions have been rising (Chart 15). As a result, depreciation expense is set to climb, cutting into margins and earnings. Chart 14Capex Surge Will Lead To Higher Depreciation Chart 15More Capex Is Under Way Interest Costs Set To Increase With Rising Rates Interest charges are small compared to other expenses, never rising above 5% of sales. There has been quite a lot of variability in interest charges in recent years, reflecting swings in both interest rates and the level of corporate borrowing (Chart 16). Falling interest costs provided a boost to profits between 2008 and 2010, as well as during the trade war and the pandemic. Also, corporations have been de-leveraging, but this trend is about to turn: As the corporate sector heals, it is likely to re-leverage, whether to finance capex or buybacks. With interest rates set to rise, interest costs are likely to become a drag on profits (Chart 17).   Chart 16Higher Rates And Corporate Re-Leveraging Will Push Interest Costs Up Chart 17Corporate Debt Has Bottomed Effective Tax Rates Are Likely To Increase Effective tax rates have fallen from about 18% in 2014-2017 to 12% in January 2018 because of the Trump Administration’s tax reform and remain low by historical standards (Chart 18). Meanwhile, taxes paid have also been hit by the 2020 downturn thanks to temporary tax breaks, and have not yet rebounded to pre-pandemic levels, thereby aiding margin expansion. However, given the Biden Administration’s push to increase the US corporate tax rate and eliminate loopholes, chances are that tax expenses will rise. Chart 18Effective Tax Rates Are Low By Historical Standards Overseas Profits So far, we have focused on the domestic drivers of changes in margins.  Yet for many US corporations, especially the ones in the S&P 500, overseas profits are a key source of profits. Many industries derive a substantial share of sales from abroad, and for Technology, this number stands as high as 58%.  Historically, overseas profits have been a tremendous source of growth (Chart 19) thanks to rising exposure to fast-growing emerging economies, a weaker dollar, and the transfer of operations to low-tax regimes. However, recently this trend has turned due to closing loopholes allowing companies to locate headquarters in lower tax regime jurisdictions, tax reform, foreign profits amnesty, and unified global pressure to tax US multinationals. Onshoring of manufacturing production is another emerging trend that is likely to improve the efficiency of supply chains but will add to production expenses, chipping away at corporate profitability. The US dollar has been weakening during the pandemic, giving a boost to profits thanks to both lower prices of the American goods and translation effects (Chart 20). Chart 19Overseas Profits Are Trending Down Chart 20USD TRW Is Strengthening Hence, we conclude that the share of overseas profits is unlikely to change and is not going to become an engine for profit growth for US corporations. Where Next For Profits? The clear implication from the above analysis is that profits have ceased to benefit from earlier benign trends in depreciation charges, interest costs, and tax rates. Looking ahead, these factors, are destined to become modest headwinds for profit growth. Sales growth is also likely to slow as GDP growth returns to trend, with overseas profits less of a source of growth. And importantly, productivity growth and pricing power have peaked and turned, depriving the economy of its key drivers of margin expansion. S&P 500 The obvious question is how all the factors affecting NIPA margins translate into the forecast for change in S&P 500 operating margins. S&P 500 margins are subject to the same profit drivers as the NIPA accounts. In order to forecast the effect of these factors on the year-on-year changes in operating margins, we have built a simple regression model that uses year-on-year changes in average hourly earnings (AHE) to capture the cost of labor; high-yield option-adjusted spreads (OAS) to capture the cost of borrowing; year-on-year PPI as a change in cost of input materials; the trade-weighted USD as an indicator capturing change in foreign profits; and, lastly, the BCA pricing power indicator to measure companies’ ability to pass on these costs to their customers (Table 1).   Table 1Regression To Predict Operating Margins YoY% The model forecast of margin growth peaked in August 2021 and is about to slow into the balance of the year (Chart 21). Margins will contract outright in December 2021-January 2022. The growth rate for margins in January 2022 is -65% year on year.  In January 2021, operating margins were 7.2%. Incorporating a negative year-on-year growth rate, we arrive at margins of only 2.6%, which is certainly very low. The caveat here is that our objective is to predict the direction of change as opposed to working out a point estimate of future margins. In other words, there is a wide confidence interval around any forecast of earnings given the unpredictability of movements in the exchange rate, productivity and the general level of economic activity. However, our assumptions are conservative, and the model clearly points to a margin contraction in 2022. Chart 21After An Impressive Surge, Margins Are Set To Decline And lastly, why will margins contract? What is the main culprit that would make things worse? The answer is an increase in input and labor costs (PPI and AHE), both of which are no longer being offset by a corporate pricing power: The ability of corporations to pass on their costs to customers has diminished, and margins are going to take a hit (Chart 22 & Table 2). Chart 22Increase In Costs Is No Longer Offset By Pricing Power Table 2Contributions To Margins Growth Bottom Line Earnings growth and profit margins are of paramount importance to the performance of equities – as we wrote in a report in August, the key driver of returns has shifted from multiple expansion to earnings growth. Despite the recent pullback, the S&P 500, trading at 20.5x forward multiples, is still expensive. Our analysis shows that S&P 500 operating margins are likely to contract in 2022 because of rising wages, a slowdown in productivity, increases in interest and depreciation expenses, and potential tax hikes. On the revenue side, US GDP growth is slowing, and corporate pricing power is waning, making it difficult to pass on rising costs to customers. Impending margin contraction does not bode well for the strong performance of US equities in the year ahead.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     Profits before tax reflect the charges used in tax accounting for inventory withdrawals and depreciation. The inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj) are used to adjust before-tax profits to NIPA asset valuation concepts. The IVA adjusts inventories to a current-cost basis, which is similar to valuation of inventory withdrawals on a last-in/first-out basis. The CCAdj adjusts tax-reported depreciation to the NIPA concept of economic depreciation (or “consumption of fixed capital”), which values fixed assets at current cost and uses consistent depreciation profiles based on used asset prices. Recommended Allocation

Highlights The surge in European natural gas prices is a consequence of China’s effort to wean itself off its coal addiction and of the energy supply problems around the world. As long as the energy price surge does not threaten a policy response by the ECB, it will not plunge Europe into a significant downturn. So far, the ECB is unlikely to respond, because a wage-inflation spiral has not developed. Natural gas prices will decline significantly over the coming months, as a result of the Nord Stream 2 pipeline and other developments around the world; thus, the energy price shock will not spill over into a durable inflation wave across the continent. Without a significant risk of premature monetary tightening, European cyclical assets will perform well over the coming 18 months. EUR/USD will stabilize in the 1.15-1.12 zone, and peripheral bonds will continue to outperform the core. Feature Europe is amidst an unprecedented energy crisis, following the past three months’ 235% and 240% increases in natural gas prices in the UK and the Netherlands’ benchmarks, respectively. Investors now begin to fear that this energy crunch will threaten the European economic recovery and could even plunge Europe into a renewed recession. Underlying inflation must rise enough to prompt a hawkish monetary policy response for the energy price spike to topple the economy. Higher energy prices alone will not be enough. Despite the current panic, more supply will make its way to Europe. Future prices are skewed to the downside from here. As a result, investors should refrain from betting on a rapid removal of monetary accommodation from the ECB. Additionally, an end to the energy crisis will allow the euro to recover and will help European cyclical assets. A Multifaceted Crisis The extraordinary spike in European energy and electricity prices reflects a rare confluence of events. Chart 1China's Wean Off From Coal First, China’s intake of natural gas is surging because of two decisions made by Beijing. The Xi Jinping administration is fighting aggressively to improve air quality in the country, because pollution is one of the population’s main worries. As a result, China is aiming to curtail the role of coal (which today accounts for 63% of its electricity production) in its energy mix; coal production is not following electricity generation (Chart 1, top panel). Coal imports are not substituting for the lack of domestic supply growth. Instead, China has cut its intake of Australian coal dramatically (Chart 1, bottom panel) in response to tensions between the two nations. Natural gas is filling the gap. Second, the rest of the world is also voraciously absorbing natural gas. The Korean economy has greatly benefited from the global rebound in industrial activity, and Japan is increasingly re-opening, a result of its accelerating vaccination campaign. Latin America has become an unusual buyer of LNG. Low rainfalls in Brazil have caused hydro-power generation to be well under normal levels this summer. As a result, natural gas shipments were also called upon to fill this gap. Third, Europe’s investment in alternatives is facing difficulties. As Chart 2 highlights, the EU generates 26% of its electricity generation from renewables; wind accounts for 55% of this category. However, as BCA’s commodity strategists recently showed, wind power generated low levels of output last summer across the EU and the UK, which occasioned a scramble for natural gas and coal power generation.  This process forced Europe to bid up LNG prices to compete with China, which caused European natural gas inventories to fall below the seasonal range of the past five years (Chart 3). Chart 2Europe’s Reliance On Renewable Chart 3Low Nat Gas Inventories Chart 4There's A Reason Why Energy Is Not Attracting Capital Fourth, the lack of investment in the energy sector over the past seven years is slowing the supply response. Much of the blame for this phenomenon has been laid on rising ESG standards, which have disincentivized banks, insurance companies, and pension plans from putting money in the energy sector. This is only partially true. The main culprit behind this lack of investment is the poor return generated in the energy sector over the past twelve years, especially compared to the tech sector. As an example, in Europe, ASML surged by more than 5000% since March 6 2009, whereas Royal Dutch Shell rose 19% (Chart 4). The former naturally attracted significantly more capital than the latter. Fifth, utilities are fearing a cold winter and are trying to stock up natural gas ahead of the cold season. The US Climate Prediction Center assigns a 70% to 80% chance of a La Niña event this winter. La Niña is a complex weather pattern that results in colder surface temperatures in the Pacific Ocean; it often produces colder temperatures across much of Western and Northern Europe. The effort to shore up depressed inventory levels ahead of this potential threat increases the pressure on natural gas prices. Bottom Line: The surge in European natural gas prices reflects a confluence of unusual forces. China is trying to move away from polluting coal electricity generation, while global demand has been buoyed by the re-opening of the economy and exceptional weather patterns. Moreover, the supply response of the energy sector is tepid following seven years of low capital investment because of low rates of returns. To add insult to injury, EU CO2 emission allocation prices reached a record of EUR64.3/ton in September, which adds to the pressure on electricity prices created by record natural gas prices. From Energy Crunch To Recession? This rapid climb in energy prices is bound to affect European economic activity in the fourth quarter as some firms must curtail production. However, important counterbalances will limit this pain. Hence, on its own, the energy crisis is unlikely to cause a major slowdown or recession. Natural gas, oil, and coal consumption only represent a small share of output at 2% of GDP, or the lowest level since 1999 (Chart 5). If we assume that all energy prices average their 2008 peaks for the next 12 months, the energy spending as a share of GDP will hit 5%, still below the 2008 apex. We do not believe average energy prices will be that high for that long (see European Nat Gas Prices Have Downside section). Thus, while the current energy prices surge is painful for many, the effective tax on the overall European economy remains manageable. Robust income expansion compensates for this small growth-tax increase. The Eurozone Gross National Income is rebounding smartly since its Q2 2020 trough. Exports outside the Eurozone are near all-time highs, and the goods and services balance of the current account is strong (Chart 6). Chart 5Energy Spending Is Small Chart 6Offsets To Rising Energy Costs Chart 7Resilient Confidence Confidence surveys remain unphased by the tumult in the energy market. The European Commission Consumer and Business Confidence Surveys stand near 3- and 14-year highs, respectively (Chart 7, top panel). The Belgian Business Confidence Survey, which historically acts as a bellwether for the whole of Europe, still stands near its all-time high. Even more surprising, the retail sales survey continues to climb higher (Chart 7, second panel). In Germany, which is historically sensitive to energy prices, the Ifo Business Climate index is remarkably stable (Chart 7, third panel). Even Italy, which is exceptionally reliant on natural gas, is resilient: Consumer confidence hit a ten-year high, and business confidence remains close to its recent record (Chart 7, bottom panel). Fiscal policy is creating another important offset to higher energy prices. Underlying government deficits are tabulated to decrease from 3.8% of GDP for the Eurozone in 2020 to 3.6% in 2021 and 1.5% in 2022. However, this is happening as private sector savings decline rapidly, the result of the re-opening of the economy and robust confidence. Instead, what matters is that the deficit will remain large by historical standards and is creating more aggregate demand than in the pre-pandemic period (Chart 8). Moreover, the NGEU funds will spend an envelop worth EUR750 billion, mostly for vulnerable economies, such as Italy or Spain. Ultimately, it requires more than just rising energy prices to prompt an economic contraction. The US provides an interesting example. As Chart 9 illustrates, when previous sharp increases in commodity prices were associated with a rapid tightening in monetary policy, a recession followed. This time around, monetary policy is looking through the surge in input prices, because global central bankers firmly believe that the recent increase in inflation is transitory. Similarly, because credit spreads remain very narrow, equity prices remain elevated, and global bond yields are still very low, global financial conditions will remain extremely accommodative. Thus, if inflation does not broaden and central bankers do not panic, growth will turn out to be fine. Chart 8No More Budget Surpluses Chart 9Higher Commodity Prices Alone Won't Cause A Recession Bottom Line: The European energy crisis is causing investors to worry, and many now fear that a major slowdown or even another contraction in output is in the offing. However, carbon-based energy represents too small a share of GDP to cause such a dire outcome, especially when income growth remains strong, confidence is elevated, and fiscal policy is broadly accommodative. Ultimately, the reaction of central bankers will determine the outlook for economic activity. Will The ECB Respond To Inflation? The hurdle is very high for the ECB to respond to the recent increase in HICP to 3.4%. To begin with, the ECB is still reeling from its decision to lift the repo rate twice, to 1.5% in 2011 when HICP reached 3% on the back of strong energy prices (Chart 10). This decision is now widely considered a policy mistake that accentuated the European sovereign debt crisis. Beyond a fear of repeating history, the ECB is constrained by the narrow nature of European inflation. As Chart 11 shows, trimmed mean CPI, which includes 84% of the consumer prices index components, remains extremely depressed by historical standards, highlighting the role of a few components in driving up overall inflation. Moreover, shelter inflation remains a tepid 1.1%. Hence, the surge in CPI reflects higher commodity prices and base-effects from the pandemic. Chart 10The 2011 Mistake Chart 11Inflation Is Still Narrowly Based Wage dynamics will determine when energy prices will cause a broad-based increase in inflation. Without significantly higher wage growth, higher energy prices are a relative price shock that saps spending in other areas. For now, the de-linking of Bund yields and European energy prices confirms we are still facing such a price shock (Chart 12, top panel). Trends in hourly earnings and negotiated wages are currently also inconsistent with generalized inflation (Chart 12, second and third panel). Obviously, the situation may change. It will require a large adjustment in expectations. For now, European inflation expectations are trending higher, but they remain mostly a function of dynamics in the energy market (Chart 13, top panel). Similarly, the fluctuations in energy prices strongly influence the perception of firms about their ability to raises prices (Chart 13, bottom panel). Chart 12A Relative Price Shock, Not Generalized Inflation Chart 13Inflation Expectations Will Follow Energy Prices Ultimately, energy price inflation must remain elevated for several more months before inflation expectations become permanently unhinged. Thus, if energy prices stabilize or decrease in the new year, then no wage-inflation spiral will develop, and the ECB will not lift policy rates and prompt a severe slowdown in economic activity. Bottom Line: Due to the memory of the 2011 policy mistake and the lack of broad-based inflationary pressures in Europe, the ECB will continue to ignore the rise in headline inflation. However, if energy price increases perdure long enough, inflation expectations and wages will become problematic. Only in this context will the ECB tighten policy and prompt a severe slowdown. European Nat Gas Prices Have Downside We expect European natural gas prices to decline significantly over the coming months, which will prevent the ECB from tightening policy too early and cause a significant growth slowdown. The opening of the Nord Stream 2 pipeline early next year is a game changer. German regulators still have to announce whether to allow deliveries to flow to the domestic market, but Russia is already filling the pipeline completed last month. Moreover, the German public widely supported the project in May (Chart 14), and the recent energy crunch must have only solidified this trend. Nord Stream 2 is key for another reason. Russia limited the inflow of gas to Europe ahead of the pipeline opening to improve its negotiation position and put pressure on Germany to accept the project. Most importantly, the IEA estimates that Russia has ample capacity to supply European gas markets, and the trend in Russian gas production remains healthy (Chart 15). Chart 14Broad-based Support For Nord Stream 2 Chart 15Nat Gas Production Profiles Outside of Russia, other gas producers will continue to ramp up production. Australia is becoming an increasingly important player in the global LNG market and its production is rising (Chart 15, second panel). Qatari production has been flat for nine years. However, recent permit auctions point toward a strong increase in production in the North Field, in the order of 40% by 2026, buttressed by $60 billion in capex from 2021 to 2025. Saudi Arabia, too, is expected to increase natural gas production from next year to 2025. Finally, US production is still expanding; the IEA expects this country to become the world’s largest LNG exporter by 2025. A large part of the fears about higher European natural gas prices over the coming months relate to La Niña. Investors understand full well that it could generate a cold winter and are focusing on this risk, which is already reflected in natural gas prices. However, La Niña also causes wetter winters in Brazil, which would allow a resumption of hydro-power generation in this market. Additionally, La Niña also results in unstable winter conditions in Northern Europe, which suggests that wind will increase; the latter would alleviate some of the problems linked to renewable power that have forced natural gas prices higher. The growth in LNG demand from Asia should also slow in the near term. China is committed to its shift away from coal-powered electricity production, but the inability to produce enough electricity has caused occasional blackouts and electricity rationing around the country. In response to these pressures, Chinese authorities have recently started to allow deliveries of Australian coal. Moreover, in Japan, Fumio Kishida, the recently elected head of the LDP, is a big supporter of nuclear energy, and he plans to re-open nuclear plants rapidly after becoming prime minister. Such a move would quickly decrease Japan’s appetite for LNG. Finally, Iran remains a wild card. Iran possesses the second largest natural gas reserves in the world after Russia and is the world’s third-largest producer. Europe currently cannot access that gas because of the US post-JCPOA sanctions. However, Israel and the US are now in favor of returning to the conditions of the JCPOA, which means that, if a deal is hastened, Iranian natural gas will find its way into the global market. While it is not a base case for 2021, it is a positive tail outcome that would have a large impact on the natural gas market and help Europe greatly. Bottom Line: European natural gas prices have likely already peaked or will do so soon. The Nord Stream 2 pipeline, which should begin deliveries this winter, is an important development, especially because Russia has the capacity to supply Europe adequately. Moreover, global production of natural gas is set to increase meaningfully over the coming years. While La Niña would result in lower winter temperatures in Europe, which boost demand, it would also help in terms of the supply of hydropower in Brazil and wind in Northern Europe; meanwhile, Japan looks set to restart nuclear power generation under a Kishida administration. Finally, both the US and Israel are warming up to a return to the JCPOA with Iran, which would result in a great increase in international supply. This last point is more a downside risk for natural gas prices than a factor we are banking on. Investment Implications We expect natural gas prices to depreciate over the coming months, and thus, the current shock will have little enduring impact on European economic activity. The lack of recession risk suggests that our 18-month preference for markets like Germany, Sweden, and small cap remains appropriate. It also means that the tactical window for Spain to outperform remains open. Peripheral spreads will also remain well behaved, and Italian, Portuguese, Greek, and Spanish bonds will outperform German and French bonds further. Without higher natural gas prices, inflation expectations will not become unanchored to the upside, and the ECB will maintain a very accommodative monetary policy. Not only will the ECB lag well behind the Fed in terms of increasing interest rates, it will also remain an active buyer of European bonds next year. We continue to be a buyer of EUR/USD in the 1.15-1.12 region. The ECB is unlikely to come to the rescue of the euro; however, tighter peripheral spreads, continued growth convergence with the US, and a rebound next year in global economic activity will help the common currency.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades   Currency Performance Fixed Income Performance Equity Performance