Emerging Markets

Highlights Gold prices will continue to be challenged by conflicting information flows regarding US monetary policy; higher inflationary impulses from commodity prices and supply-chain bottlenecks; global economic policy uncertainty, and risks to EM economic growth (Chart of the Week). Concern over the likely tapering of the Fed's asset-purchase program this year, rate hikes next year and fiscal-policy uncertainty will support rising interest-rate risk premia and a stronger USD. These will remain headwinds for gold. Going into the Northern Hemisphere's winter, risk premia in fossil-fuel prices are at or close to their zeniths, as is the Bloomberg commodity index. This will keep short-term inflation elevated. Heightened geopolitical tensions – particularly between Western democracies and China – will keep the USD well bid by risk-averse investors. The commodity-induced element of PCEPI inflation will be transitory. Uncertainty over US monetary policy and rising geopolitical tensions, however, will remain part and parcel of gold fundamentals indefinitely. The trailing stop on our long 1Q22 natural gas call spread – long $5.00/MMBtu call vs. short $5.50/MMBtu call – was elected, leaving us with a 20% gain. We will not be re-setting the spread at tonight's close, due to the difficulty in taking a price view in markets with extremely high weather-related uncertainty. Feature The quality of information informing the analysis of gold markets is highly uncertain at present. US monetary policy uncertainty and the future of Fed chairman Jerome Powell keep expectations twitchy when it comes issues like the tapering of the Fed's asset-purchase program. Our colleagues at BCA's US Bond Strategy expect the Fed will announce a taper in asset purchases by November 2021 which will end in June 2022.1 But the tapering really is not, in our estimation, as big a deal as inflation and inflation expectations, which will drive the Fed's rate-hiking timetable. Chart of the WeekUncertainty Weighs On Gold Uncertainty Weighs On Gold Uncertainty Weighs On Gold The first Fed rate hike expected by our bond desk likely will come at the end of next year. Our colleagues expect the Fed will want to check off three criteria before increasing interest rates (Table 1). The inflation targets – actual and expected – already have been checked off, leaving the labor market's recovery as the only outstanding issue on our internal checklist. By December 2022, once the maximum employment criterion has been met, the Fed will commence with rate hike.2 Subsequent rate hikes will depend on inflation expectations. Table 1A Checklist For Liftoff Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold Uncertain Inflation Expectations The higher inflation that checks off our bond desk's list resulted from COVID-19-impacted services and tight auto markets (Chart 2). We also find evidence commodities feed into inflation expectations and realized inflation, both of which are key variables for the Fed (Chart 3). Transitory effects – chiefly supply-chain bottlenecks and a global scramble for coal, gas and oil – have lifted realized inflation in 2H21, and have taken the Bloomberg commodity index to record levels (Chart 4). Nonetheless, given the fundamental backdrop for the key industrial commodities – chiefly oil, gas, coal and base metals – the inflationary impulse from commodity markets could persist indefinitely into the future, in our estimation. In order to incentivize the investment in base metals needed to literally build out the renewable energy infrastructure, the grids that support it and the electric vehicles that will supplant internal-combustion-engine technology, higher energy and metals prices will be required for years.3 This will be occurring as the production of traditional energy sources – i.e., fossil fuels – winds down due to lower investment over the next 10-20 years. This also will result in higher and more volatile oil and gas prices. Chart 2Inflation Meets Fed Targets Inflation Meets Fed Targets Inflation Meets Fed Targets Chart 3Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations All of these real-economy factors will feed into higher inflation over time, which will present the Fed with difficult choices regarding monetary policy and interest rates. Chart 4Record Commodity Index Levels Record Commodity Index Levels Record Commodity Index Levels USD Strength Suppresses Inflation And Gold Prices  It is worthwhile noting the current USD strength is suppressing inflation. However, it is not suppressing commodity prices entirely, as Chart 4 shows. The transitory weather-related price increases in energy commodities will pass, either when winter ends or if a less severe winter hits the Northern Hemisphere. We continue to expect a lower dollar, as the Fed's accommodative monetary policy remains in place. Even after the Fed tapers its asset-purchase program, policy will remain loose. The large fiscal packages that most likely will be approved by the US Congress will swell the US debt and budget deficits, which likely will weaken the USD over time. On a purchasing-power-parity basis (PPP) we also expect a weaker dollar (Chart 5). We also are expecting the availability of more efficacious vaccines in EM economies to boost economic activity, which will strengthen incomes and local currencies vis-à-vis the USD. Chart 5Weaker USD Expected On A PPP Basis Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold The risk to this USD view – which would support gold prices – remains the heightened geopolitical tensions between Western democracies and China, which will keep political uncertainty elevated and will keep the USD well bid by risk-averse investors. Persistent USD strength would restrain inflation, and weaken the case for owning gold. Investment Implications We remain bullish gold over the medium- and long-term, expecting higher inflation and inflation expectations to lift demand for this safe haven. However, persistent commodity-induced inflation could force the Fed to tighten monetary policy more than is currently expected to get out ahead of higher inflation and inflation expectations. This could lead to stagflation, wherein inflation runs high but growth stalls as interest rates move higher. Persistent geopolitical risk also will keep risk-averse investors well bid for the USD. Commodities Round-Up Energy: Bullish First-line US natural gas prices were down ~ 9% as we went to press, following reports Russia would make more gas available to European buyers. This report apparently was later contradicted by a Gazprom official, who said Russian inventories still were being filled ahead of winter.4 WTI crude oil prices came close to hitting a seven-year high early in the trading day Wednesday, then promptly retreated (Chart 6). The news flow is indicative of the extreme sensitivity of gas and oil buyers going into the coming winter. Base Metals: Bullish Earlier this week, the Peruvian government struck an deal with MMG Ltd, owner of the Las Bambas mine, and the local community around the site, which reportedly will involve hiring local residents to provide services to the mine, including helping transport minerals and maintaining key transit roads. The community had been protesting to seek more of the income from the mine, and created blockades en route to the site, which threatened ~ 2% of global copper supply. Peru's newly elected president, TK Castillo, rose to power on the promise to redistribute mining wealth to Peruvian citizens. This was his first negotiation with a mining company since his election in July. MMG’s major shareholder is China Minmetals Corp. The Leftist president will need to balance the interests of local stakeholders on the one hand, while ensuring the world’s second largest copper producing nation is still attractive to international miners. Precious Metals: Bullish In 2021, the World Platinum Investment Council expects the platinum to swing to a physical surplus of 190k oz, which reverses an earlier forecast for a deficit made in the Council's 1Q21 report (Chart 7). Demand is forecast to increase year-over-year, spurred by increases in automotive, industrial and jewelry demand. On the supply side, growth in South Africa's mined output growth will keep markets in a surplus for 2021. According to SFA Oxford, gross palladium demand and refined supply for 2021 are expected to be at 10.03mm oz, and 6.77mm, respectively. Palladium balances (ex-ETFs) are projected to remain in a physical deficit of 495k ounces for 2021. Chart 6 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 7 Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Footnotes 1     Please see Damage Assessment, published by BCA Research's US Bond Strategy on September 28, 2021. 2     Please see 2022 Will Be All About Inflation, published by BCA Research's US Bond Strategy on September 14, 2021, which notes the concept of maximum employment is not a well-defined term. 3    Please see La Niña And The Energy Transition, which we published last week. 4    Please see Energy price surge sends shivers through markets as Europe looks to Russia published by reuters.com on September 6, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Highlights Indian stock outperformance versus its EM peers has gone vertical. This is unsustainable, and a period of indigestion is likely. We are booking profits on our overweight position and downgrading this market to neutral within overall EM and emerging Asian equity portfolios. That said, India’s medium- and long-term growth and profit outlook remain positive. There are indications that the ongoing expansion could be sustainable as it’s shaping up to be capex-led rather than consumption-led. Feature Chart 1Indian Stock Outperformance Has Gone Vertical Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now We are recommending equity investors book profits on their overweight position in Indian stocks and downgrade this market to a neutral allocation in EM and emerging Asia equity portfolios. This call is tactical in nature – to protect profits – and does not portend a medium- and long-term bearish view on the country. India’s cyclical macro-outlook remains positive, and the profit cycle has further to run. That said, both absolute and relative return investors will likely get a better entry point in the months ahead. A Vertical Rise There are several reasons for our recommendation to book profits: In recent months Indian stocks have gone up vertically both in absolute and relative terms (Chart 1). If history is any guide, this is unsustainable. Back in 2007 and in 2014, this bourse experienced similar surges in relative performance – in terms of duration and magnitude – which were then followed by periods of underperformance. Granted, those were towards the end of a business cycle, as opposed to the beginning of a new cycle as is now the case. Nevertheless, this can still result in a period of indigestion. Incidentally, the steep outperformance versus EM is not simply due to the meltdown in Chinese TMT stocks. Even if we exclude all EM TMT stocks from our calculations, India’s equity outperformance profile remains relatively unchanged (Chart 2). Relative valuations have also become stretched. The cyclically adjusted P/E ratios of Indian stocks vis-à-vis those of the EM and emerging Asia have risen to a level not seen since the early 1990s. This calls for caution (Chart 3). Chart 2Indian Stock Outperformance Is Not Just Due To Chinese TMT Stock Meltdown Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now Chart 3India's Cyclically-Adjusted P/E Ratio Versus EM Is At All-Time Highs Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now   Net foreign equity inflows, which were extremely high earlier this year, and which contributed greatly to the rally in Indian equities, have since slowed down to a trickle (Chart 4). It seems that the rally of the last couple of months has been due to local retail investors. If so, retail investors typically go with momentum and might be quick to sell if the market corrects. Finally, energy prices have risen materially over recent months. Given that India is a large net oil importer, rising oil prices have always been bearish for Indian stocks’ relative performance. Yet, so far in this cycle, India has been able to escape the negative ramifications. Now, with oil at over $80 a barrel and still rising, the old negative correlations will likely be back (Chart 5). This will not bode well for Indian markets. Chart 4Foreign Net Equity Inflows To India Have Slowed Down To A Trickle Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now Chart 5Rising Crude Oil Price Are Usually A Headwind For India's Relative Stock Performance Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now   Yet, The Profit Cycle May Have Further To Run Indian firms’ profits have recovered rather strongly. Chart 6 shows that gross profits (EBITDA) of non-financial firms have surged above their pre-pandemic levels. This is also the case even when it is measured in US dollar terms. What is also important to note is that most of this surge has come from a material improvement in profit margins – as opposed to sales. The bottom panel of Chart 6 shows that the top line (sales) of the non-financial firms are yet to surpass the pre-pandemic levels, in stark contrast to profits. The upshot is that the non-financial firms’ margins, both gross and net, have risen to their respective decade-high levels (Chart 7, top panel). Chart 6India's Corporate Profits Have Surged Despite Sluggish Sales Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now Chart 7Lower Costs Have Led To Booming Gross And Net Margins For Indian Firms Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now   We get the same picture if we look at a much wider range of companies: all listed non-financial firms in India. The bottom panel of Chart 7 shows the margin profiles of over 2600 Indian firms compiled by the RBI,1 and it gives a very similar message. Margin expansion of this order is indicative of material efficiency gains – in this case, primarily, cost reduction. If firms can largely hold on to these gains – maintain wide profit margins, once and when sales accelerate – corporate earnings will be turbo-charged. We are biased to believe that the corporate sector will likely be able to sustain its improved margins: One of the major costs of any firm – wages – will likely stay low. The top panel of Chart 8 shows measures of salary expectations from an industrial survey from RBI. Both the assessment for the current quarter and the expectation for the next quarter has been a net negative for some time. In future, wages are not expected to rise much either as millions of new jobseekers will routinely enter the job market every year. In fact, the massive, but likely temporary, contraction in the labor force in 2020 – caused by the COVID-19 pandemic – means that over the next couple of years there will likely be a spike in the number of job seekers. This is because many of last year’s temporarily discouraged workers will return to the job market, in addition to the regular inflows of new job seekers. The wage picture is not much different in the rural hinterlands. The bottom panel of Chart 8 shows that rural wages, for both agricultural and non-agricultural workers, have stopped rising even in nominal terms. In fact, rural wage growth has been quite mediocre over the past several years. If wage pressures stay low, it will also help keep general inflation under control. Indeed, India’s inflation outlook remains benign. Both core and headline inflation are headed lower as projected by our respective inflation models (Chart 9). We elaborated on India’s inflation outlook in greater detail in our last report on India: Can Inflation Upset The Indian Applecart? Chart 8Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now Chart 9... And A Benign Inflation Outlook Will Keep Borrowing Costs Low Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now   A benign inflation outlook entails that interest rates are unlikely to rise much. Therefore, firms are going to benefit on both accounts: low wage bills and low interest costs. If costs stay low, margins can stay wide. If margins remain wide, with the top line recovery, profits will accelerate further. This is why we think the profit cycle is not yet over, even though we are recommending a tactical downgrade on Indian equities to protect profits. A Capex-Led Expansion? Chart 10Surging Profits Have Helped Kickstart A New Capex Cycle In India Book Profits On Indian Stocks, For Now Book Profits On Indian Stocks, For Now A massive profit surge early in the recovery has major positive externalities. High profits usually beget strong capex. And a capex-led expansion is extremely important for India, as this will be a crucial factor in determining the sustainability and magnitude of this cycle. The indications so far are positive: Strong profits have indeed helped kickstart capital spending in India (Chart 10). Profits that stay robust – as we expect them to – should entice further capital spending. Other corroborative data also indicate a new capex cycle. Despite the pandemic-related disruptions, net FDI inflows into India have surged to near all-time highs. Imports of capital goods are also strong and rising. Strong capex does more than boost firm competitiveness and profits in the long run. It also helps alleviate structural inflationary pressures in an economy – something that could be a major positive for India. Notably, the long-term trajectory of India’s real capex relative to consumption had been up. Even over the past year or so, the country’s real capital spending has been growing at a rate superior to that of consumption. This will help keep inflationary pressures at bay. Finally, given the sobering wage outlook, it’s difficult to imagine any imminent consumption rush. Putting it all together, it appears that the coming cyclical expansion will likely be capex-led. Investment Conclusions Equities: Dedicated EM and Asian equity portfolio managers should book profits on their overweight position in India and downgrade this market from overweight to neutral. Initially, we recommended overweighting Indian equities on February 3rd. Then, we tactically downgraded this market to neutral due to the ravaging COVID-19 pandemic, but re-instated our overweight on Indian stocks on June 23. Over these two periods of our overweight, this bourse has outperformed the EM benchmark by 21.4%. We recommend absolute return investors also book profits and stay on the sidelines for now to wait for a better entry point. Currency and Bonds: The rupee is cheap and will likely be one of the best performers in the EM world over the cyclical horizon. Indian government bonds also offer good value with a rather high yield (6.26% for 10-year securities) amid a benign inflation outlook. A positive currency outlook enhances the appeal of Indian bonds for foreign investors. Please refer to our recent report The Rupee Has A Tailwind; And Bonds Offer Good Value for a detailed discussion on the rupee and local currency government bonds. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1  The Reserve Bank of India, the central bank.

Highlights Electricity shortages in China are largely due to excessive power demand rather than a matter of shrinking electricity production. Chinese electricity consumption has been supercharged by the export sector’s booming demand for electricity. Excessive overseas (mainly US) demand for goods has been the main culprit behind China’s robust electricity demand. Divergence in the mainland economy between booming exports on the one hand and weakening property construction and infrastructure spending on the other hand will reduce the likelihood that policymakers will rush to stimulate. Odds are that Chinese and EM share prices will continue selling off and underperforming DM equities. Feature Contrary to popular perceptions, China’s electricity crisis is not due to drastic supply shortages but rather caused by excessive demand. This has implications for macro policy. Given that electricity shortages stem from strong demand, policymakers will be less aggressive in providing blanket stimulus over the near term. The basis is that unleashing more stimulus to boost the industrial sector – at a time when there are already scarcities of electricity and other inputs – will intensify the shortages and aggravate the situation. Robust Electricity Demand Electricity demand has been outstripping growing electricity output. Hence, shortages are largely due to excessive electricity demand. Charts 1 and 2 demonstrate that both electricity consumption and output have been expanding but demand growth has outpacing supply. Notably, electricity demand has surged above its trend by more than electricity production.  Chart 1Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chart 2Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend The mainland’s electricity demand has been strong due to surging manufacturing consumption of electricity. The top panel of Chart 3illustrates that electricity consumption in manufacturing has become overextended. On the other hand, residential demand for electricity has been expanding gradually and has not been excessive (Chart 3, bottom panel). The manufacturing sector has been supercharged by booming exports. Chart 4 reveals that China’s industrial output and exports have expanded briskly – their levels have surged well above their 10-year trend. Chart 3Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Chart 4Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Chart 5US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating DM countries’ stimulus has been responsible for this export boom. Specifically, US demand for goods has been running well above its pre-pandemic trend (Chart 5). Bottom Line: Both electricity consumption and production have been rising but demand has outstripped supply, resulting in shortages. On Supply Constraints Not only has total electricity output been rising but electricity produced by thermal coal has also been expanding, albeit gradually (Chart 6). China still generates 71% of its electricity using thermal coal. While electricity output growth from this source has slowed down recently, it has still not contracted (Chart 7). Chart 6China: Sources Of Electricity Production China: Sources Of Electricity Production China: Sources Of Electricity Production Chart 7Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted   Similarly, coal supply has been rising slowly, i.e., it has not shrunk (Chart 8). Coal supply has been capped due to the following reasons: Coal production has decelerated due to decarbonization policies adopted by Beijing. Authorities have also constrained coal mining by strictly enforcing safety protocols in mines following accidents early this year. Moreover, coal imports have been constrained by Beijing's ban on coal from Australia. Beijing’s “dual control” policy – which imposes targets on energy intensity and the level of energy consumption on provinces – has also led several local governments to reduce electricity production in recent weeks to ensure that annual targets are met. Finally, in recent years electricity prices have been flat-to-down while coal prices have surged (Chart 9). Thus, coal-based power generators have recently been incurring losses and some of them have been reluctant to produce more electricity. Chart 8China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid   Chart 9Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses   Authorities have begun tackling these problems. Coal supply will likely rise moderately as will electricity output from thermal coal. Reportedly, some Australian coal has in recent days been offloaded in China, and authorities have eased restriction on coal production and encouraged banks to lend to coal producers and electricity generators. Bottom Line: There has been a slowdown – not a contraction – in electricity produced by thermal coal. Authorities have started addressing these bottlenecks and odds are that electricity output will catch up with electricity demand before year-end, i.e., the power shortages will likely gradually ebb. Implications For Chinese Macro Policy Given that electricity demand has been outstripping supply, clients might wonder about the pace of China’s economic growth. This has ramifications as to whether or not authorities will stimulate aggressively. On the one hand, the manufacturing and especially export-oriented segments have been expanding briskly. As shown in Chart 4 above, manufacturing output in general and exports in particular have been overheating. Further, the labor market has been tightening, as is illustrated in Chart 10. On the other hand, as we have been writing, construction and infrastructure spending have been weakening (Chart 11). Chart 10China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight Chart 11Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Granted property developers, local governments and LGFVs are facing debt limits and financing constraints, it is safe to assume that they will cut back on their capital spending. China’s construction and infrastructure spending accounts for a large share of industrial metals demand. This is a basis for our argument that industrial metal prices remain at risk of declining. Unlike the current power crunch, industrial metal shortages are not caused by excessive demand but rather are due to shrinking production. Chart 12 shows that China’s steel output has contracted. Hence, the surge in steel prices has been due to production cutbacks. Local governments are probably shutting down metals production in response to decarbonization policies and to divert power to export-oriented companies. The fact that the price of steel’s key ingredient – iron ore – has collapsed is consistent with reduced demand for it (Chart 13). This is in contrast with the current strong demand for coal. Chart 12Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Chart 13Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Overall, the bifurcation in the economy characterized by booming exports versus weakening property construction and infrastructure spending reduces the likelihood that policymakers will rush to stimulate. Rather, they will provide targeted support to negatively affected segments of the economy in the form of easier credit access, easing industry regulation and easier decarbonization targets. Bottom Line: Policymakers in Beijing will not rush to provide a blanket stimulus for now. Rather, they will use this period of booming exports to undertake deleveraging in the real estate sector as well as local governments and their affiliated companies. Investment Implications: Barring any large stimulus, construction and infrastructure spending will continue to disappoint, which is bad for industrial metals. This outlook in combination with the ongoing regulatory clampdown on internet companies heralds lower prices for Chinese investable stocks. Chart 14Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Given that Chinese investable stocks include few export companies, booming exports will not be sufficient to propel China’s MSCI Investable equity index higher. Among the Chinese indexes, we reiterate our long A shares / short China MSCI Investable index strategy, a recommendation made in early March (Chart 14). Reshuffling The EM Portfolio BCA’s Emerging Markets Strategy team is recommending the following changes in country allocation within EM equity and fixed-income portfolios. Equities: We are downgrading Indian stocks from overweight to neutral. The reasons for this portfolio shift are presented in the country report we are publishing today. In its place, dedicated EM equity managers should upgrade Russian and Central European equity markets like Poland, Czech Republic and Hungary from neutral to overweight. The rationale is that high oil prices favor Russian equity outperformance. Barring a major crash in oil prices, we are comfortable maintaining an overweight allocation to Russia in an EM portfolio. ​​​​​​​In turn, rising bond yields in core Europe are positive for bank stocks that have a large weight in Central European bourses.   Fixed Income: We are upgrading Russian local currency bonds from neutral to overweight within an EM domestic bond portfolio. A hawkish central bank is positive for the long end of the Russian yield curve. 10-year yields also offer great value. Further, high energy prices (even if they drop from current very elevated levels but remain above $60 per a barrel) will help the ruble to outperform its EM peers. We maintain a yield curve trade of receiving 10-year/paying 1-year swap rates in Russia. Finally, we continue overweighting Russian sovereign and corporate credit within an EM credit portfolio.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

  Highlights Chart 1Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond yields rose notably in September, with the bulk of the move coming in the days after the Fed teased an upcoming tapering of its asset purchases and revealed slightly hawkish revisions to its interest rate projections. Interestingly, some of the details of the bond market move don’t mesh nicely with the mildly hawkish policy surprise that the Fed delivered. For example, the Treasury curve steepened on the month and long-maturity TIPS breakeven inflation rates rose. Our sense is that September’s market moves were less driven by the Fed and more by a revival of the reflation (or re-opening) trade from earlier this year. The daily new US COVID case count ticked down and, while overall S&P 500 returns were negative on the month, a basket of equities designed to profit from the end of the pandemic soundly beat a basket of “COVID winners” (Chart 1). With the delta COVID wave receding, we remain confident that economic growth will be sufficiently strong for the Fed to launch a new rate hike cycle in December 2022. The Treasury curve will bear-flatten as that outcome gets priced in.   Feature Table 1Recommended Portfolio Specification A Bout Of Reflation A Bout Of Reflation Table 2Fixed Income Sector Performance A Bout Of Reflation A Bout Of Reflation Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to +193 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Bout Of Reflation A Bout Of Reflation Table 3BCorporate Sector Risk Vs. Reward* A Bout Of Reflation A Bout Of Reflation High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 53 basis points in September, bringing year-to-date excess returns up to 558 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first eight months of the year, well below the estimate generated by our macro model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, bringing year-to-date excess returns up to -43 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 19 bps in September. The spread is wide compared to recent history, but it remains tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 6 bps in September to reach 31 bps (panel 3). This is above the 22 bps offered by Aaa-rated consumer ABS but below the 52 bps offered by Aa-rated corporate bonds and the 33 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 15 basis points in September, dragging year-to-date excess returns down to +69 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in September, dragging year-to-date excess returns down to -87 bps. Foreign Agencies outperformed the Treasury benchmark by 5 bps on the month, bringing year-to-date excess returns up to +49 bps. Local Authority bonds outperformed by 24 bps in September, bringing year-to-date excess returns up to +406 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to +24 bps. Supranationals underperformed by 4 bps, dragging year-to-date excess returns down to +27 bps. Last week’s report looked at performance and valuation trends for Emerging Market sovereign and corporate bonds relative to US corporates.6 The recent underperformance of EM bonds versus US corporates has led to attractive relative valuations in the sector. We see investment grade EM sovereign and corporate bonds both outperforming investment grade US corporates during the next 12 months. The outperformance will be the result of better starting valuations and an acceleration of EM growth in 2022. The bonds of Colombia, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar look particularly attractive within the USD-denominated EM sovereign space. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in September, bringing year-to-date excess returns up to +292 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 Both General Obligation (GO) and Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporate bonds with the same credit rating and duration (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in September, with yields moving sharply higher – especially in the 5-10 year maturity space. The 2-year/10-year Treasury slope steepened 14 bps to end the month at 124 bps. The 5-year/30-year slope flattened 5 bps to end the month at 110 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 2.08%, the 5-year/5-year forward Treasury yield is already within our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.30% in one year’s time and 1.62% in five years (Chart 7). The latter rate has 131 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 256 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in September, bringing year-to-date excess returns up to +627 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month, while the 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps. At 2.41%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to a steepening of the inflation curve (bottom panel). We recommend that investors position for a steeper 2/10 inflation curve, or alternatively for a flatter 2/10 real Treasury curve. We noted in last week’s report that the combination of nominal curve flattening and inflation curve steepening will lead to a large flattening of the 2/10 real curve during the next 6-12 months.9The 2-year TIPS yield, in particular, has a lot of upside.                         ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent nominal Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +43 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +32 bps. Non-Aaa ABS outperformed by 7 bps, bringing year-to-date excess returns up to +99 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +195 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 bps in September, bringing year-to-date excess returns up to +96 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 4 bps on the month, dragging year-to-date excess returns down to +525 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +94 bps. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -17 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 17 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) A Bout Of Reflation A Bout Of Reflation Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3  Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5  Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8  Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 9  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021.