Financial Markets

Dear Client, There will be no weekly report next week. Instead, we will host our quarterly webcast on Tuesday, October 26 for the US and EMEA regions and Wednesday, October 27 for the Asia Pacific region. We will resume our regular publishing schedule on Monday, November 1. In the meantime, we look forward to seeing many of you at our BCA Research Investment Conference this week. Best regards, Mathieu Savary   Highlights This year’s decline in EUR/USD has rendered this pair sufficiently inexpensive and oversold to account for the near-term risks we highlighted in March. Nonetheless, some risks remain—among them, the continued credit slowdown in China, diverging monetary policy trends, and the energy crisis hurting Europe. However, long-term fundamentals continue to support the euro’s 12- to 18-month outlook. Moreover, Chinese credit growth may soon stabilize and markets already largely factor in the policy divergence between the Fed and the ECB. As a result, we buy the euro today with a preliminary target at 1.25 and a stop loss at 1.1175. The Bank of England will lift rates this December, but the market already prices in a hawkish BoE. GBP/USD has upside, even if the euro should outpace the pound in the coming months. Look to upgrade UK small-cap stocks. Italian equities do not appear particularly appealing on a cyclical horizon, neither in absolute nor relative terms. Investors should favor Spanish stocks over Italian ones for the next 12-to-18 months. Feature EUR/USD recently flirted with 1.15. Did this move create a buying opportunity? Last March, we warned that the euro would correct to the 1.12 to 1.15 zone because short-term models flagged it as expensive, speculators carried a substantial net-long exposure, and Chinese credit growth was set to slow meaningfully. These forces have now mostly played out; thus, the euro’s near-term outlook is becoming more positive. Despite this more constructive view, EUR/USD still carries ample downside risks, especially if Chinese authorities remain reluctant to reflate their economy. Moreover, the energy crisis facing Europe clouds the euro. We are nonetheless buyers of EUR/USD, with a target at 1.25. Investors should set a wide stop in at 1.1175. Cheap And Oversold The internal dynamics of the euro indicate that the bulk of the sell-off is behind us. First, the euro is now cheap on a tactical basis. Back in March, our short-term fair value model for EUR/USD flagged at 7% overvaluation based on real rate differentials, on the slope of the German yield curve relative to that of the US, and on the copper-to-lumber prices ratio. Today, this same measure shows a 5% undervaluation. BCA’s Foreign Exchange Strategy Intermediate Term Timing Model (ITTM) flags an even clearer buy signal.  The ITTM framework combines interest rate parity models, with risk aversion and considerations for the currency’s trend. Currently, this model is at -8% or nearly minus one standard error. Historically, such a depressed reading points to generous returns in the subsequent 12 months (Chart 1). Second, the euro is oversold. BCA’s Intermediate Term Technical Indicator has hit 7, which is consistent with past rebounds in EUR/USD (Chart 2). While some of these rallies have been extremely short-lived, the technical indicator’s message is stronger when it is matched by a buy signal from the ITTM. Chart 1Strong Buy Signal From Short-Term Valuations Chart 2EUR/USD is Oversold Chart 3Stale Euro Longs Have Been Purged Third, speculators do not carry a large net long position in the euro anymore. This variable suggests that the worst of the selling pressure is behind us, but it has yet to send a strong buy signal on its own (Chart 3). Bottom Line: The euro is sufficiently inexpensive that our Intermediate-term timing model flags a strong buy signal. Moreover, our technical indicators paint an oversold picture consistent with a reversal. Nonetheless, speculators may not be long EUR/USD anymore, but they are not aggressively selling it either. Thus, macro dynamics remain important to the future trend of this currency. Macro Fog Remains The macro environment is not yet conducive to a euro rally, especially when Chinese credit growth remains weak. However, considering the euro’s valuation and technical picture, small changes in the macro environment could be enough to catalyze a jump in EUR/USD. A key problem for the euro is that the dollar remains well bid. The yen and the dollar are the two momentum currencies within the G-10 (Chart 4). This property of the dollar is a large handicap for the euro, because it remains the most liquid vehicle to bet on the USD. Thus, as long as the dollar’s momentum is strong, the euro will find it difficult to rally. Relative economic growth is another headwind for EUR/USD. European activity is weakening versus that of the US. Since 2019, the relative manufacturing PMIs between the Euro Area and the US track EUR/USD, and they currently confirm the euro’s weakness (Chart 5). Moreover, European economic surprises are significantly weaker than US ones, which adds to the euro’s malaise (Chart 5, bottom panel). Chart 4The Dollar Is A Momentum Currency Chart 5Deteriorating European Growth Hurts EUR/USD The near-term outlook does not signal a resolution of this issue until the first half of 2022. The declines in the expectation and current situation components of both the ZEW and Sentix surveys herald an additional deceleration in manufacturing activity (Chart 6). The Eurozone’s growth problems reflect China’s slowing credit flows. Europe economic activity is still extremely sensitive to the evolution of the global industrial cycle (Chart 7, top panel), much more so than the US GDP is. China’s business cycle is an essential determinant of the robustness of the global manufacturing sector. Consequently, when measures of China’s marginal propensity to consume decelerate, such as the gap between M1 and M2 growth, European PMIs and industrial production underperform those of the US (Chart 7, second and bottom panels). Chart 6A Bit More Time Before Europe's Slowdown Ends Chart 7China's Travails Hurt Europe     The fourth quarter of 2021 is likely to represent the tail end of the Chinese headwind on EUR/USD. The Chinese credit impulse remains weak, but signs of a floor are beginning to appear. For example, the decline in Chinese commercial banks excess reserve growth warned us of the coming decline in the credit impulse. Today, excess reserves have begun to stabilize, which points to an upcoming imporvement in credit flows (Chart 8). Additionally, the Evergrande problems continue to weigh on Europe in the near-term because of the deceleration in Chinese construction activity;  however, the crisis will also intensify the pressure on Beijing to revive credit growth in order to avoid a systemic collapse. Chart 8Will China's Credit Impulse Bottom Soon? Monetary policy differentials also remain euro bearish. The US Federal Reserve will announce the start of its tapering program on November 3. The FOMC is set to hike rates by the end of 2022. Meanwhile, the ECB is unphased by the increase in European inflation, which remains mostly a reflection of energy prices and base effects. Thus, Europe will lag behind the US when it comes to monetary policy tightening. Nonetheless, investors already understand this dichotomy very well. The US OIS curve anticipates four hikes in 2023. Meanwhile, the EONIA curve shows a first 25-bps hike only by September 2023. Thus, the euro will suffer more from policy differentials if the Fed generates hawkish surprises relative to this pricing. The energy crisis shaking Europe is the last major headwind currently affecting the euro. Historically, EUR/USD and the ratio of European to US natural gas prices track each other (Chart 9). This relationship reflects relative growth dynamics. A stronger Eurozone economy relative to the US pushes up the value of the euro and European natural gas, which is a commodity with heavy industrial usage.  However, since this summer, the spike in European natural gas prices has coincided with a decline in the euro. This divergence highlights the negative effect on European activity of the current energy shock, which raises fears of stagflation. The cross-Atlantic bond market dynamics confirm the notion that the energy shock increases the perceived stagflation risk in the Eurozone. German yields have risen relative to US ones because of a pick-up in inflation expectations, not real rates (Chart 10). The lack of traction for relative real rates is appropriate because market participants believe that the ECB wants to ignore the spike in energy prices. An environment of rising relative inflation expectations but stable relative real rates is very negative for any currency, including the euro. However, European inflation expectations should decrease relative to those of the US once European natural gas prices normalize, which we expect to take place in the coming months (Chart 10, bottom panel). This process will be very positive for the euro. Chart 9The European Energy Crisis Harms The Euro Chart 10Pricing In European Stagflation? Bottom Line: While euro pricing and technicals suggest EUR/USD will bottom soon, the economic environment is murkier. The dollar is a momentum currency, and its current strength feeds the euro’s weakness. China’s credit flows continue to decelerate, which hurts the euro; however, credit flows may stabilize in early 2022. The Fed is a tailwind for the dollar, but markets already price in this reality. Finally, the energy crisis hurts European growth and thus EUR/USD; nonetheless, the spike in natural gas prices will soon give way to a period of decline, which will lessen the pain for the euro. What To Do? When we balance the positives and negative for the euro, we are becoming more comfortable with buying EUR/USD outright, even if it is still a risky bet. To begin with, the big fundamental forces point to a firmer euro on an 18- to 24-month basis: BCA’s Foreign Exchange strategists see greater cyclical downside for the USD and believe the current rebound is a pronounced countertrend move within a multi-year dollar bear market. The euro will naturally benefit over the coming years from a weak greenback. EUR/USD is still inexpensive on long-term valuation metrics. Based on BCA’s purchasing power parity model, this pair trades 17% below its fair value. Moreover, the PPP estimate keeps rising in favor of the euro, a result of the Eurozone’s lower inflation compared to the US (Chart 11). The relative balance of payments favors the euro. The European economy generates a current account surplus of 3% of GDP compared to a current account deficit of 3.1% for the US. The US current account deficit is unlikely to narrow, even if the federal government’s budget hole declines because the private sector’s savings rate is falling even faster. Moreover, US real two-year rates remain well below those of its trading partners. Investors underweight Eurozone assets aggressively. For the past ten years, capital has consistently flowed out of the Euro Area relative to the US (Chart 12). European growth should converge toward the US next year, especially if Chinese credit activity stabilizes. Therefore, 2022 should witness a period of inflows into the Eurozone. Chart 11EUR/USD Significant Long-Term Discount Chart 12Investors Underweight Eurozone Assets We argued that the valuation and technical backdrop shows the Euro is becoming increasingly supportive and our timing model is clearly arguing against selling EUR/USD. However, the biggest technical risk is the momentum sensitivity of the dollar, which means that the euro’s weakness could last somewhat longer. Nevertheless, BCA’s Dollar Capitulation Index now warns of a pullback in the USD, especially as speculators are very long DXY futures (Chart 13). The biggest downside risk remains China’s credit trend. If it takes more time than we anticipate for Beijing to put an end to the credit impulse slowdown, the euro will experience greater downside pressure. Moreover, the longer it takes Beijing to reflate, the greater the chance of an uncontrolled selloff in the CNY, which would drag down the euro (Chart 14). Chart 13Is The Dollar Technically Vulnerable? Chart 14China Remains The Euro's Main Risk Despite this level of near-term uncertainty, we recommend investors buy the euro, with a target at 1.25, and a stop loss at 1.1175. Bottom Line: Conditions are falling in place for the countertrend decline in the euro to end soon. As a result, the euro should converge back toward the upward path driven by fundamentals. The greatest near-term risk remains the path of Chinese credit trends. We recommend investors buy the euro with a preliminary target at EUR1.25 and a stop loss at 1.1175.   Country Focus: A Well Discounted BoE Hike The Bank of England will begin to increase interest rates at its December meeting. The BoE’s communication has been clear that it does not see a need to wait between the end of its tapering program in December and the beginning of its hiking campaign. Recent comments by senior MPC members, including new Chief Economist Huw Pill, also suggest a rate hike is looming. Chart 15The BoE's Inflation Problem We see little reason to doubt the willingness of the MPC to start lifting the Bank Rate. UK Core CPI stands at 3.1% or 110 basis points above the BoE’s inflation target. Moreover, both market-based and survey-based long-term inflation expectations are well above 3.5%, which increases the risk of a dangerous dis-anchoring of UK inflation (Chart 15). UK economic activity remains inflationary. Wages are strong, climbing 7.2% in August. This number probably exaggerates the underlying wage growth due to compositional effects, but job creation remains robust and the unemployment rate fell to 5.2%. The BoE was concerned that the end of the furlough scheme last month would cause a jump in unemployment, but their fears have dwindled, because job vacancies stand at a record high and capex intentions are solid (Chart 16). The housing market continues to be a tailwind to growth. House prices are up 10% annually, which lifts household net worth considerably (Chart 17). The pace of transactions in the real estate market will slow this spring because the stamp duty holiday will end; however, low mortgage rates and expectations of further housing gains may fuel greater appreciation. This creates long-term financial stability risks for the UK because household leverage will rise. This worries the BoE. Chart 16The UK's Labor Market Strength Will Continue Chart 17Rising Household Net Worth Market participants already expect a hawkish BoE. A rate hike is priced in for December and the SONIA curve embeds almost two more increases in 2022. The 4.3% underperformance of the UK government bond index over the global benchmark in seven weeks also underscores the rapid adjustment in investors’ perceptions of the UK policy path. BCA’s Global Fixed-Income strategists have underweighted UK government bonds for two months, and they maintain a negative view over the coming quarters.  Nonetheless, the risk of a short-lived countertrend rebound in UK bonds’ relative performance is significant. However, it would be a temporary position squaring, while hedge funds and CTAs take profits. BCA’s Foreign Exchange strategists expect GBP/USD to rebound. Cable is oversold and trades at a 12% discount to BCA’s PPP fair-value estimate. GBP/USD is also hurt by fears that the BoE hikes will damage the UK economy. From a contrarian perspective, this creates a positive entry point to buy cable, especially because the pound should benefit from the anticipated dollar weakness and the euro’s upcoming rally. However, BCA’s FX strategists also foresee some decline in the pound versus the euro, because GBP is a low beta play on EUR/USD. Hence, the trade-weighted pound could remain flat to slightly down in the coming months. We stay neutral on UK small-cap stocks relative to large-cap equities, but we are putting them on an upgrade alert. Small-cap stocks benefit from the strength in the domestic economy; however, they are also extremely expensive compared to large-cap ones (Chart 18). The arbiter of performance will be profits. The forward EPS of small-caps have lagged behind those of large-caps by 9% since the COVID recession, after underperforming since 2016 (Chart 19). Small-caps’ relative profits are currently trying to stabilize, but the durability of this trend will be tested if the trade-weighted pound remains flat in the coming months. Thus, the EPS of small-cap shares must regain more ground before moving more aggressively in this market. Chart 18UK Small Cap Are Pricey Chart 19Follow The Profits Bottom Line: On the back of a strong UK economy and significant inflationary forces, the BoE will start elevating interest rates this December. The market already prices in this outcome. Nonetheless, UK bonds should continue to underperform the global benchmark, and cable has upside, even if the near-term outlook favors the EUR over the GBP. We are putting UK small-cap stocks on a buy alert. They are expensive, but a turnaround in profits would solve this problem. Market Focus: A Quick Take On Italian Equities The Italian equity market remains Europe’s problem child. The Italian MSCI index has underperformed the rest of the Euro Area by 40% since 2010. This underperformance holds even after adjusting for sectoral differences, although it becomes less dramatic (Chart 20, top panel). Despite this underperformance, Italian equities have managed to outperform their Spanish counterparts by 27% since 2010, but this outperformance dissipates once sectoral difference are accounted for (Chart 20, bottom panel). The RoE of Italian non-financial listed equities is equivalent to the rest of the Eurozone, but it only reflects elevated financial leverage, as is the case in Spain (Chart 21). Italy’s RoA is poor, because Italy’s excess capital stocks hurts its return on capital. As a result, Italian equities continue to face a structural handicap. Chart 20A Problem Child Chart 21Italy's Return On Asset Is Poor The good run in Italian equities in absolute terms faces headwinds. Italian stocks are very sensitive to the global business cycle; however, they often respond with a delay and in an exaggerated fashion to decelerations in the global PMI (Chart 22, top panel). Moreover, since 2010, widening European high-yield corporate bond spreads have preceded falling Italian stock prices. Thus, the recent slide in the global PMI and the widening in European high-yield OAS create a period of vulnerability for Italian equities. Finally, Italian share prices have overshot the path implied by US yields (Chart 22, bottom panel). Nonetheless, Italian stocks may be sniffing out further increases in global yields. The cleanest way to play these vulnerabilities in the Italian is via a short bet against Spain. A steeper global yield curve will help both markets due to their heavy exposure to financials. However, we still favor Spanish financials, which benefit from higher RoEs than their Italian counterparts (Chart 23) and lower NPLs. As a result, the forward EPS of Spanish financials should begin to outperform those of Italian financials. Chart 22Some Risks To Italian Stocks Chart 23Spanish Banks Are Better Placed To Benefit From Rising Global Yields   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Chart 7Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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 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 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 Chart 3Commodities 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 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 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 Chart 7   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 Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations      

Highlights European small-cap equities have structurally outperformed large-cap stocks. This outperformance echoes the desirable sectoral biases of small-cap stocks. It also reflects the inability of European large-cap stocks to expand their markups, unlike US large caps. The pro-cyclicality of European small-cap stocks and the limited correlation of their relative performance to the Chinese credit cycle make them an attractive play in European portfolios. The current risk-off phase in global markets suggests it is still too early to buy European small-cap stocks, but an opportunity to overweight them will emerge in the coming weeks. Feature Markets last week were volatile and corrected sharply. This fit with the view expressed in our previous strategy report, which argued that the near-term outlook for European equities was still clouded by the confluence of the coming Fed tightening and a Chinese economic slowdown.  Chart 1Ebbing COVID Allows For Central Bank Repricing The market seems especially concerned by the deterioration in liquidity conditions. The Delta wave is ebbing around the world (Chart 1) and inflation is proving to be stickier than policymakers had originally anticipated. As a result, investors appear to be pricing in the potential implications of central banks moving from being behind the curve to ahead of the curve. Moreover, surging natural gas prices in Europe, empty gas stations in the UK, labor shortages around the world, and steep automobile production cuts by major players like Toyota and GM raise the specter of stagflation. In this context, bond yields are rising and stocks are agitated. The dollar’s rally further tightens global financial conditions and adds to the systemic stress, which intensifies the very unsettling environment for investors. Consequently, seasonal October weakness remains on the table. Chart 2Tactical Vulnerabilities Remain We continue to see this selling phase as temporary. Sentiment will be consistent with a trough in risk assets soon (Chart 2). Additionally, Chinese authorities will reflate the economy much more aggressively than they have so far, even if it probably takes more market pain first. In this context, we focus on what to buy to take advantage of the eventual rebound in cyclical plays. This week, we look at European small-cap stocks that have handsomely outperformed their larger counterparts over the past ten years. In Europe, Small Is Beautiful Chart 3Small Caps Lead In Europe The underperformance of European stocks relative to the US over the past 13 years is well known by investors. Less known is that, since 2012, European small-cap stocks have performed roughly in line with their US counterparts. In other words, European small-cap stocks have massively outperformed Euro Area equity benchmarks (Chart 3). Two forces explain the ability of European small caps to beat their larger competitors by 85% since the Great Financial Crisis. The sectoral composition of European small-cap indexes helped them outperform their larger competitors. Using MSCI benchmarks, the small-cap index largest overweight are industrials and real estate, compared to financials, healthcare, and consumer staples for large caps (Table 1). Industrials have been one of the best performing sectors in the cyclicals and value categories, while financials have greatly suffered. Meanwhile, real estate equities enjoy falling yields, while financials hate them. This dichotomy explains why European small caps outperformed as European yields collapse (Chart 4). It is also why, unlike in the US, the relative performance of European small-cap equities exhibits little correlation with the slope of the yield curve. Table 1Small Caps Overweighs The Right Sectors Chart 4European Small Caps Like Lower Bund Yields The poor performance of the European large-cap stocks is the second element explaining the outperformance of European small caps. The European large-cap stocks lie at the heart of Europe’s underperformance relative to the US, not the smaller firms. According to researchers De Loecker, Eeckhout, and Unger, US firms have grown their markups massively since the 1980s (Chart 5).1 These expanding markups reflect a growing market power, which is the result of rising market concentration among the dominant players in nearly all the industries.2 In fact, Grullon, Larkin & Michaely show that industries with a greater level of concentration also display higher levels of RoA (Chart 6).3 The problem for European large firms is that they have not experienced the same increase in industry concentration as US businesses. Research by the OECD demonstrates that industry concentration rose significantly more in the US than in Europe over the past 20 years (Chart 7). This is particularly true in the service sector (Chart 7, middle panel) and the less digital-intensive industries (Chart 7, bottom panel).4 Chart 5Higher US Markups Chart 6As Concentration Increases, So Do RoAs Chart 7Europe Did Not Witness The Same Increase In Concentration Without this increase in market power, European large caps could not experience a meaningful pick up in their RoEs relative to those of small-cap stocks. They have therefore been fully victim to their sector composition and massively underperform smaller firms as well as US large businesses. Bottom Line: The structural outperformance of European small caps relative to large-cap stocks reflects the former’s large overweight in industrials and real estate stocks compared to the latter’s overrepresentation of financials, healthcare, and consumer staples names. Additionally, the inability of large-cap European names to increase industrial concentration has prevented them from mimicking the extraordinary growth in markups and RoE witnessed in the US. As a result, European small-cap names could massively beat their larger counterparts. Can The Outperformance Continue? The structural outperformance of small caps will become challenged if Europe experiences a structural increase in yields, which will hurt real estate stocks while helping financials. This sectoral effect will result in a structural outperformance of European stocks. On a cyclical horizon, however, the outlook continues to favor small-cap over large-cap equities in Europe and the Eurozone. Chart 8The Relative Performance Of European Small Caps is Procyclical As in the US, the relative performance of European small-cap stocks is pro-cyclical. As Chart 8 shows, small-cap stocks generate the largest excess returns at the beginning of business cycle upswings. They continue to outperform, as long as the business cycle points up. Only once a slowdown begins do small- cap names underperform. Similarly, the relative performance of small-cap equities correlates closely with the Euro Area Manufacturing PMI (Chart 9). It also displays a negative correlation with high-yield spreads (Chart 9, middle panel). Additionally, small-cap stocks track the evolution of inflation swaps (Chart 9, bottom panel). This behavior of small caps means that they remain an attractive bet over the next 18 to 24 months. The European economy is likely to continue to grow robustly over the coming two years and thus stay in the quadrant where small caps outperform. Moreover, the ECB’s policy will generate very accommodative monetary conditions for an extended period. Hence, European high-yield bonds will continue to outperform safe havens and the labor market will tighten further, which will help CPI swap climb up. Despite this procyclicality, the relative performance of small-cap stocks displays only a loose correlation with the European cyclical/defensive split (Chart 10). Moreover, small caps do not correlate closely with commodity prices (Chart 10 middle panel). These two observations reflect the limited relationship between the relative performance of small-cap equities and the Chinese credit impulse (Chart 10, bottom panel). The small caps’ lack of sensitivity to the Chinese economy is the consequence of their lower international bent compared to that of large-cap firms. Chart 9More Signs Of Procyclicality Chart 10Low Correlation To China Plays This low correlation with Chinese economic variables is likely to prove another asset for small-cap equities. As we have witnessed with the Evergrande saga or the rotating crackdowns from one industry to the next, China will remain a source of uncertainty for the global economy and global capital markets for the foreseeable future. Thus, a low-correlation relative performance is an attractive attribute. Chart 11Not Particularly Cheap European small-cap stocks are not without blemish. Unlike in the US, they trade at a premium to large-cap stocks on many valuation metrics. For example, their price-to-forward earnings, price-to-trailing earnings, price-to-cash flow ratios and dividend yields stands at 21 vs 16, 35 vs 35, 18 vs 10 and 1.2% vs 2%, respectively. True, small-cap indexes carry a large proportion of companies with negative earnings. Adjusting for this characteristic, the forward P/E ratio falls to 15.12, which is just under the similarly adjusted forward P/E ratio of the Eurozone benchmark. Our Composite Small Cap Relative Valuation Indicator, which amalgamates this information, is directly in the neutral zone (Chart 11). The neutral relative valuation of small-cap stocks is a handicap because they sport operating metrics that are worse than their larger cousins. Their RoE are a meagre 6.3% vs 7.7%. Moreover, forward earnings have rebounded sharply already and long-term growth expectations are lofty (Chart 12). This leaves the euro as the ultimate arbiter of the path of European small caps. As Chart 13 illustrates, the trade-weighted euro closely tracks the relative performance of the Euro Area small-cap benchmark. This reflects the more domestic nature of small caps, but also, their procyclicality, which mimics that of the euro. Chart 12Some Good News In The Price Chart 13A Play On The Euro Chart 14A Weaker Yuan Could Lift The Dollar The euro continues to face near-term hurdles, which creates a problem for small-cap stocks. The dollar is catching a bid as the Fed moves closer to its tapering and eventual rate hike. Moreover, interest rate differentials between China and the US are narrowing, which will weigh on the yuan (Chart 14). A weaker CNY often causes EM currencies to depreciate and puts downward pressure on the euro. Furthermore, if the global equity correction perdures a few more weeks, the dollar will benefit from additional risk-off flows, which will also hurt the euro. Beyond these near-term risks, BCA’s foreign exchange strategists continue to hold a positive cyclical outlook on the dollar. The greenback’s defining characteristic is its counter-cyclicality. Thus, BCA’s expectation that the period of risks to global growth is temporary also means that the dollar’s rally has a finite life. As we argued last week, Chinese policymakers are unlikely to let the economic deterioration fester for too long, as it would risk uncontrolled deleveraging pressures. Moreover, global capex and inventory trends also point toward a growth re-acceleration in the first half of 2022.  In this environment, the euro—which still behaves as the anti-dollar—will be able to regain its footing. Therefore, we will not chase EUR/USD below the 1.15 - 1.12 zone.  Chart 15History Rhymes The near-term risks to the euro and small-cap stocks create a buying opportunity for investors with a 12- to 18-month investment horizon. A short period of small-cap underperformance will allow small-cap equities to digest completely the period of outperformance that took place between March 2020 and June 2021 (Chart 15). It will also follow the pattern of the past ten years, wherein periods of outperformance last 18 to 24 months and are followed by a short decline before resuming anew.  Bottom line: Small-cap stocks are an attractive vehicle to bet on pro-cyclical assets in Europe. They have benefited from a structural outperformance as a result of their attractive sectoral profile. Moreover, their relative performance strengthens when the global business cycle is in expansion, yet it is a rare cyclical asset with a limited correlation to Chinese credit trends. European small-cap stocks are tightly correlated with the trade-weighted euro. In the near term, this could cause a period of underperformance to develop; however, this is a buying opportunity for investors with a 12- to 18-month investment horizon. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1J. De Loecker, J. Eeckhout, G. Unger, “The Rise Of Market Power And The Macroeconomic Implications,” Mimeo 2018. 2Please see The Bank Credit Analyst Section II "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bcaresearch.com 3G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 4Bajgar, M., et al. (2019), “Industry Concentration in Europe and North America,” OECD Productivity Working Papers, No. 18, OECD Publishing, Paris, https://doi.org/10.1787/2ff98246-en. 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