Germany

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights US Vs. Europe: Growth and inflation momentum remains stronger in the US versus Europe. The latter is taking the bigger economic hit from more severe Omicron economic restrictions and a greater exposure to slowing Chinese demand. European inflation has accelerated, but remains slower and less broad-based than elevated US inflation. The backdrop remains more negative for US fixed income compared to Europe. UST-Bund Spread: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures). Feature Chart of the WeekUS Bond Yields & Bond Volatility Are Both Rising Global fixed income markets are off to a volatile start in 2022, on the back of significant repricing of US interest rate expectations. The 10-year US Treasury yield now sits at 1.85%, up +34bps so far in January and is up +72bps from the August 4/2021 intraday low of 1.13%. The 2-year US yield, which is even more sensitive to changes in Fed expectations, is 1.04%, up +31bps so far this month and up +87bps since early August 2021. Yields are rising in other countries as well, with the 10-year benchmark government bond yield up year-to-date in the UK (+24bps), Canada (+45bps) and even Germany (+18bps) where the Bund yield is threatening to return to positive territory. US Treasuries are selling off as markets have heeded the hawkish shift in the Fed’s interest rate guidance. The US overnight index swap (OIS) curve now discounting 89bps of Fed rate hikes in 2022. Bond volatility further out the Treasury curve has increased as yields have moved higher, with the realized volatility of the Bloomberg 7-10 US Treasury index now at an 19-month high (Chart of the Week). We continue to recommend a defensive strategic posture towards direct US Treasuries with below-benchmark exposure on both duration and country allocations in global bond portfolios. However, we prefer a more efficient way to position for the same theme of rising US yields – betting on a wider 10-year US Treasury-German Bund spread. US Growth & Inflation Fundamentals Support A More Hawkish Fed The rise in global bond yields seen in recent weeks has inflicted damage on risk assets, but not in a consistent fashion. Equity markets have taken the brunt of the hit, with the S&P 500 down around -3% so far in January with the tech-heavy NASDAQ down -6%. Yet the MSCI emerging market equity index is up around +1%, European equities are flat and global high-yield corporate bond spreads are essentially unchanged so far this month. While higher bond yields are reflecting expectations of more global monetary tightening over the next year, medium-term interest rate expectations remain subdued. Our proxy for the market pricing of terminal interest rate expectations – 5-year OIS rates, 5-years forward – remains at or below pre-pandemic levels in the US, the UK, Canada and the euro area (Chart 2). Risk assets are performing relatively well in the face of higher bond yields because markets still do not believe that a major increase in interest rates will be needed in the current global tightening cycle. We see this – the likelihood that interest rates will have to rise much more than markets expect - as the biggest vulnerability for global bond markets over the next couple of years. The US remains the “poster child” for this view. In the US, core CPI inflation accelerated to an 31-year high of 5.5% in December. The pickup in US inflation continues to be broad-based, with the Cleveland Fed median CPI and trimmed mean CPI inflation measures reaching 3.8% and 4.8%, respectively (Chart 3). This massive run-up in US inflation has filtered through to medium-term household inflation expectations; the preliminary University of Michigan consumer survey for January showed that inflation 5-10 years out is expected to be 3.1% - the highest level in 13 years. Chart 2Rising Yields Are Not A Threat To Risk Assets ... Yet​​​​​ Chart 3The Fed Cannot Ignore Elevated Inflation Expectations​​​​​​ Chart 4US Demand Steadily Normalizing From The Pandemic Shock While much of the run-up in US inflation over the past year has been fueled by supply chain disruption and high energy prices, there is still a robust demand component to the high inflation. Consumer spending on goods remains elevated versus its pre-pandemic trend, while services spending is steadily returning back to the pre-pandemic pace (Chart 4). The overall US unemployment rate is now down to 3.9%, the lowest level since February 2020, with broad-based strength in the US labor market across most industries (bottom panel). The rise in consumer inflation expectations has to be most worrisome to Fed officials. Yes, market-based inflation expectations have already seen a significant run-up since the mid-2020 lows, and have even drifted down a bit of late on the back of the more hawkish rhetoric from the Fed. However, survey-based measures of inflation expectations tend to be less volatile than market-based measures, and typically follow trends in realized inflation, which is not slowing down in the US. In other words, rising household inflation expectations are a more reliable indication that an inflationary mindset is becoming entrenched in consumer behavior. US inflation dynamics are transitioning away from supply-driven goods inflation toward more lasting domestically driven forces like tight labor markets, faster wage growth and rising housing costs (Chart 5). Measures of supply chain disruption like global shipping costs are showing signs of peaking (top panel), while commodity price momentum has clearly rolled over – both should eventually feed into slower goods inflation this year. At the same time, tight labor markets will continue to boost US employment costs, which historically have been strongly correlated to US services inflation (middle panel). Chart 5US Inflation Pressures Remain Intense Meanwhile, shelter costs, which represents 32% of the US CPI index, were up 4.2% on a year-over-year basis in December and are likely to continue accelerating given a dearth of housing supply versus demand that is pushing up both house prices and rents (bottom panel). Tying it all together, there are good reasons why the Fed has ramped up the hawkish rhetoric over the past couple of months. However, with the US OIS curve now discounting between 3-4 rate hikes in 2022, it will be harder to generate a second consecutive year of negative returns in the US Treasury market this year. Dating back to the early 1970s, there have only been five calendar years where the Bloomberg US Treasury index delivered an outright negative total return: 1994, 1999, 2009, 2013 and 2021 (Chart 6). None of the four cases prior to last year saw negative returns in the following year, as Treasury yields fell in 1995, 2000, 2010, 2014. Yet even the episodes that saw consecutive years of US yield increases – 1974-75, 1977-81, 1987-88, 2005-06 and 2015-16 – did not see outright negative returns from the Bloomberg US Treasury index. Chart 6Negative Return Years For US Treasuries Are Rare Given the starting point of deeply negative real US bond yields, and interest rate expectations that remain too low beyond 2022, we still see value in staying below-benchmark on US duration exposure on a medium-term basis. However, we see a more efficient way to play for higher Treasury yields this year by positioning US Treasury underweights/shorts versus overweights/longs in government bonds in a region where discounted rate hikes will not happen – Europe. The ECB Is In No Hurry To Hike Rates The same supply driven factors that have pushed up US inflation over the past year have also lifted inflation in the euro area. Headline HICP inflation reached an 30-year high of 5.0% in December, while core HICP inflation hit an all-time high of 2.6%. The European Central Bank (ECB), however, is unlikely to deliver any rate hikes in 2022 even with the high inflation, for several reasons (Chart 7): Growth momentum entering 2022 was soft, thanks to Omicron related economic restrictions at the end of 2021 and also weak demand for European exports from China. It will take time for both of those factors to reverse, thus reducing any growth related pressure to tighten monetary policy. Inflation expectations are not exceeding the ECB 2% inflation target, with the 5-year/5-year forward EUR CPI swap now at 1.9% even with headline inflation of 5.0%. The surge in European energy prices will eventually subside in the first half of 2022, which will reduce inflationary pressure on the ECB to tighten. The ECB is ending its pandemic emergency bond buying program (PEPP) in March, and is only partially replacing that buying activity by upsizing its existing pre-pandemic asset purchase program (APP). The ECB will not want to compound the effect of this “tapering” of bond buying by also hiking interest rates, which would surely tighten financial conditions further through higher Italian government bond yields, rising corporate bond yields and a firmer euro. There is little evidence to date showing any pass-through of higher energy-fueled inflation into more domestically-driven inflation. Euro area wage growth was only 1.3% as of the latest available data in Q3/2021 (which is still well after realized inflation had started to accelerate), highlighting the lack of visible “second round” effects on euro area inflation from high energy prices that would prompt the ECB to consider rate hikes (Chart 8). Chart 7An ECB Rate Hike In 2022 Is Unlikely​​​​​​ Chart 8Limited 'Second Round' Effects From Energy-Driven European Inflation​​​​​​ The EUR OIS curve is discounting 7bps of rate hikes by year-end. Even that modest amount will not be delivered, which will limit how much further European government bond yields will rise this year. A Better Mousetrap: Playing UST Bearishness Through UST-Bund Spread Widening Trades Combining our view of an increasingly hawkish Fed and a still-dovish ECB produces our highest conviction investment recommendation for 2022: positioning for a wider 10-year US Treasury/Germany Bund spread. This can be done by underweighting the US versus core Europe in global bond portfolios, or shorting US Treasury futures versus German Bund futures as we are already recommending in our Tactical Trade Overlay (see page 15). A Treasury-Bund spread widening view is a more efficient way to play for a more hawkish Fed and higher US Treasury yields, for several reasons: There are many examples over past 30 years where the Treasury-Bund spread widened in consecutive years (Chart 9). This is in contrast to the fewer occurrences of consecutive years of rising Treasury yields shown earlier in this report. Thus, there are better odds that last year’s Treasury-Bund spread widening can be repeated in 2022. Chart 9Consecutive Years Of A Rising UST-Bund Spread Happen Often The realized volatility of Treasury-Bund spread trades is almost always lower than that of an outright short position in US Treasuries, but the direction of returns of the two trades is similar (Chart 10). This shows that there is directionality in the Treasury-Bund spread (i.e. it is driven far more by the movements of US yields), but that is a welcome feature given our more bearish view on US Treasuries. The Treasury-Bund spread remains well below fair value on our fundamental valuation model, with fair value increasing due to widening US-European inflation differentials (Chart 11). Tighter relative monetary policies this year (more tapering and rate hikes from the Fed compared to the ECB) also favor a wider fair value spread on our model. Chart 10UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts​​​​​ Chart 11The UST-Bund Spread Looks Very Cheap On Our Model​​​​​​ The gap between our 24-month discounters, which measure the change in policy interest rates over the next two years discounted in OIS curves, for the US and euro area is a reliable leading indicator of the 10-year Treasury-Bund spread (Chart 12, bottom panel). The “discounter spread” is currently calling for the Treasury-Bund spread to widen by more than the current path discounted in US Treasury and German Bund forward rates. Chart 12Position For More UST-Bund Spread Widening In 2022​​​​​​ Chart 13UST-Bund Spread Is Not Technically Stretched​​​​​ The Treasury-Bund spread is not stretched from a technical perspective (Chart 13). The spread is sitting right at its 200-day moving average and the 26-week change in the spread (a measure of price momentum) is rising but remains well below previous peak levels that have capped past spread increases. Summing it all up, the case is strong for including US-Germany spread widening positions as core holdings in investor portfolios in 2022. The current spread is 185bps and we have a year-end target of 225bps. Bottom Line: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation 

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Chart 2Natgas Storage Remains Tight US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 Chart 6       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Special Report

Highlights Germany’s election on September 26 is more of an opportunity than a risk for global investors. Coalition formation will prolong uncertainty but the key takeaway is that early or aggressive fiscal tightening is off the table for Germany … and hence the EU. Germany’s left wing is surprising to the upside as predicted, but it is the Social Democrats rather than the Greens who have momentum in the polls. This is a market-positive development. A coalition of only left-wing parties is entirely possible, but there is a 65% chance that the Christian Democrats (or Free Democrats) will take part in the next coalition to get a majority government. This would constrain business unfriendly outcomes. The German economy is likely to slow for the remainder of 2021, but the outlook for 2022 remains bright as the current headwinds facing the country will dissipate, especially if the risk of an aggressive fiscal drag is low. The underperformance of German equities relative to their Eurozone counterparts is long in the tooth. A combination of valuation, earnings momentum and technical factors suggests that German stocks will beat their peers next year. German equities will also outperform Bunds, which offer particularly unattractive prospective returns. Feature Germany’s federal election will be held on September 26. Our forecast that the left wing will surprise to the upside remains on track, albeit with the Social Democrats rather than the Greens surging to the forefront of opinion polls (Chart 1). However, the precise composition of the next government is very much in the air. Chart 1German Election: Social Democrats Take The Lead Our quantitative German election model – which we introduce in this special report – predicts that the ruling Christian Democratic Union will outperform their current 21% standing in opinion polls, winning as much as 33% of the popular vote. Subjectively, this seems like an overestimation, but it goes to show that outgoing Chancellor Angela Merkel’s popularity, a historically strong voting base, and the economic recovery will help the party pare its losses this year. This finding, combined with the strong momentum for the Social Democrats, suggests that the election outcome will not be decisive. Germany will end up with either a grand coalition that includes Merkel’s Christian Democrats or a left-wing coalition that lacks a majority in parliament.1 Investors should note that none of the election outcomes are hugely disruptive to domestic or foreign policy. The status quo is unexciting but not market-negative, while a surprise left-wing victory would mean more reflation in the short run but a roll back of some pro-business policies in the long run. More broadly Germany has established a national consensus that rests on European integration, looser fiscal policy, renewable energy, and qualified engagement with autocratic powers like Russia and China. The chief takeaway is that fiscal policy will not be tightened too soon – and could be loosened substantially. Germany’s Fiscal Question Outgoing Chancellor Angela Merkel is stepping down after ruling Germany since 2005. The Christian Democratic Union, and its Bavarian sister party the Christian Social Union, together form the “Union” that is hard to beat in German elections, having occupied the chancellor’s office for 57 out of 72 years. However, both the Christian Democrats and the Social Democrats, their main rivals, have been shedding popular vote share since 1990, as other parties like the Greens, Free Democrats, the Left, and Alternative for Germany have gained traction (Table 1). Table 1Germany: Traditional Parties Lose Vote Share Over Time The Great Recession and European sovereign debt crisis ushered in a new geopolitical and macroeconomic context that Merkel reluctantly helped Germany and the EU navigate. Germany’s clashes with the European periphery ultimately resulted in deeper EU integration, in accordance with Germany’s grand strategy and Merkel’s own strategy. But just as the euro crisis receded, a series of shocks elsewhere threatened to upend Germany’s position as one of the biggest economic winners of the post-Cold War world. The sluggish aftermath of the financial crisis, the Russian invasion of Crimea, the Syrian refugee crisis, the Brexit referendum, and President Trump’s election in the US sparked a retreat from globalization, a direct threat to an export-oriented manufacturing economy like Germany. In the 2017 election the Union lost 13.4 percentage points compared to the 2013 election. Minor parties have gradually gained ground since then. However, through a coalition with the Social Democrats, Merkel and her party managed to retain control of the government. This grand coalition eased the country’s fiscal belt in response to the trade war and global slowdown in 2019, signaling Germany’s own shift away from fiscal austerity. Then COVID-19 struck, prompting a much larger fiscal expansion to tide over the economy amid social lockdowns. Germany was not the largest EU member in terms of fiscal stimulus but nor was it the smallest (Chart 2). It joined with France to negotiate a mutual debt plan to rescue the broader EU economy and deepen integration. Chart 2Germany’s Fiscal Stimulus Ranks In The Middle Of Major Countries Germany’s pro-EU perspective has been reinforced by Brexit and is not on the ballot in 2021. Immigration and terrorism have temporarily subsided as voter concerns. The focus of the 2021 election is how to get through the pandemic and rebuild the German economy for the future. For investors the chief question is whether conservatives will have enough sway in the next government to try to semi-normalize policy and consolidate budgets in the coming years, or whether a left-wing coalition will take charge, expanding on Germany’s proactive fiscal turn. The latter has consequences for broader EU fiscal normalization as well since Germany is traditionally the prime enforcer of deficit limits. The latest opinion polls point to more proactive fiscal policy. The country’s left-leaning ideological bloc has taken the lead (Chart 3A) and the Social Democratic leader Olaf Scholz has sprung into first place among the chancellor candidates (Chart 3B). Chart 3AGermany: Voting Intentions Favor Left-Leaning Parties Chart 3BSocial Democrats Likely To Take Chancellery Scholz has served as finance minister and is the face of the country’s recent fiscal stimulus efforts. Public opinion is clearly rewarding him for this stance as well as his party, which was previously in the doldrums.2 The Social Democrats and Greens are calling for more fiscal expansion as well as wage hikes and tax hikes (wealth redistribution) in pursuit of social equality and a greener economy (Table 2). If the Christian Democrats retain a significant role in the future coalition, these initiatives will be blunted – not to say halted entirely. But if the left parties put together a ruling coalition without the Christian Democrats, then they will be able to launch more ambitious tax-and-spend policies. Opinion polls show that voters still slightly favor coalitions that include the Christian Democrats, although momentum has shifted sharply in favor of a left-wing coalition (Chart 4). Table 2German Party Platforms Chart 4Voters Evenly Split On Whether Next Coalition Should Include CDU This shift is what we forecast in previous reports but now the question is whether the left-wing parties can actually win enough seats to put together a majority coalition. That is a tall order. Our quantitative election model suggests that the Christian Democrats, having suffered a long overdue downgrade in expectations, will not utterly collapse when the final vote is tallied. While we do not expect them to retain the chancellorship, momentum will have to shift even further in the opposition’s favor over the next two weeks to produce a majority coalition that excludes the Union. Our Quantitative German Election Model Our model is based off the work of Norpoth and Geschwend, who created a simple linear model to predict the vote share that incumbent governing parties or coalitions will obtain in impending elections.3 Their model utilizes three explanatory variables and has a sample size of 18 previous elections, covering elections from 1953 to 2017. Our model updates their original work to make estimates for the 2021 election. Unlike our US Political Strategy Presidential Model, which makes use of both political and economic explanatory variables in real time, our German election model makes predictions based solely on historical political variables, all of which display a high degree of correlation with popular vote share. We will look at economic factors that may affect the election later in this report. The Three Explanatory Variables 1. Chancellor Approval Rating: This variable captures the short-term support rate of the incumbent chancellor. A positive relationship exists between chancellor approval and vote share: higher approval equates to higher vote share for the incumbent party. Merkel’s approval stands at 64% today which is a boon for the otherwise beleaguered Christian Democrats (Chart 5). Chart 5Merkel's Coattails A Boon But Not Enough To Save Her Party 2. Long-term partisanship: This variable shows the long-term support rate of voters for specific parties or coalitions in past elections. It is measured as the average vote share of the incumbent party over the past three elections. A positive relationship with vote share exists here too: higher historical partisanship equates to a higher share of votes in forthcoming elections, and vice versa. This variable clearly gives a boost to the Christian Democrats – although it could overrate them based on past performance, as occurred in 2017 when they underperformed the model’s prediction.4 3. “Time For Change”: This is a categorical variable measured by how many terms the parties or coalition have held office leading into an election. This variable has a negative relationship with vote share outcomes. The longer an incumbent party or coalition holds office, the less vote share they will receive. Effectively, our model punishes parties that hold office for long periods of time. In this case that would be the long-ruling Christian Democrats. Model Estimation And Results Our model is estimated by the following simple equation: Popular Vote Share = constant + ßChancellor Approval Rating + ßLong-Term Partisanship + ßTime For Change Estimating the above model for the 2021 election predicts that the Union will win 32.7% of the vote share (Table 3). If this prediction came true, it would suggest that the ruling party performed almost exactly the same as in 2017. In other words, the party’s strong voter base combined with Merkel’s long coattails are expected to shore up the party. This flies in opinion polling, however, so we think the model is overestimating the Christian Democrats. Table 3Our German Election Quant Model Says CDU Will Not Collapse Note that even if the Union performs this well, it still will not win enough seats to govern on its own. Potential Union-led coalitions are shown in Table 3, excluding the Social Democrats (see below). For a majority government, a coalition with the Free Democrats and the Greens would need to be formed. This coalition would equate to 53% of the vote share. Otherwise, to obtain a majority, the Union would have to team up with the Social Democrats, which is today’s status quo. We can use the same methodology to predict the vote share for the Social Democrats. We use the support rate of Social Democratic chancellor-candidate Olaf Scholz and calculate the long-term partisanship variable using past Social Democratic vote shares. In this case our model predicts that the Social Democrats will win 22.1% of the vote. If this result were to come true, it would not be enough for the party to govern own its own. Potential Social Democratic-led coalitions are shown in Table 4. The best coalition would be with the Greens and either the Left or the Free Democrats. But in this case the Social Democrats cannot form a government with a vote share above 50%, unless it pairs up with the Christian Democrats. Table 4Our German Election Quant Model Says SPD Has Not Yet Won It All In other words, either the left-wing parties must build on their current momentum and outperform their historical record in the final election tally, or they will need to form a coalition with the Christian Democrats. This kind of left-wing surge is precisely what we have predicted. But the model helps put into perspective how difficult it will be for the left-leaning parties to get a majority. Scholz is single-handedly trying to overcome the long downtrend of the Social Democrats. His party is rising at the expense of the Greens, and the Left, which puts a lid on the total left-wing coalition size. If these three parties all beat the model and slightly surpass their top vote share in recent memory (SPD at 26%, Greens at 11%, and the Left at 12%), they still only have 49% of the vote. While our model is reliant on historical political data, it is a robust predictor for past election results (Chart 6). The average vote share error between the predicted and realized outcomes over from 1953 to 2013 is 1.7 percentage points. The problem with relying on the model is that the Christian Democrats have broken down from their long-term trend in opinion polls. And while Merkel’s approval is strong, she is no longer on the ballot and her hand-picked successor, Armin Laschet, is floundering in the polls (see Chart 3B above). Chart 6Our German Election Quant Model Has Solid Track Record, But Merkel’s High Approval Rating Caused Overestimate In 2017 And May Do So In 2021 In short, the model is probably overrating the Union but it is also calling attention to the extreme difficulty of the left-wing parties forming a majority coalition. Scholz may have to form a coalition with the Free Democrats or pursue another grand coalition. And if the Social Democrats fail to get the largest vote share, German President Frank-Walter Steinmeier may ask Armin Laschet to try to form a government first. Still, Scholz is the most likely chancellor when all is said and done. Election Model Takeaway Our German election model predicts that the Union will receive 32.9% of the popular vote, while the Social Democrats will receive 22.1%. At the same time, the left-leaning parties, specifically the Social Democrats, clearly have the momentum. Therefore the model may be overrating the incumbent party. But it still calls attention to a high level of uncertainty, the likelihood of a messy election outcome, and a tricky period of coalition formation. The Social Democrats will have to pull off a major surprise, outperforming both history and our model, to lead a majority government without the Christian Democrats.5 We still think this is possible. But we will stick with our earlier subjective probabilities: 65% odds that the Christian Democrats take part in the next coalition, 35% odds that they do not. Bottom Line: The chancellorship will go to the Social Democrats but the coalition will constrain the business unfriendly aspects of their agenda. This is positive for Germany’s corporate earnings outlook. Macro Outlook: A Temporary Economic Dip Our election model does not account for the economic backdrop and hence ignores the “pocketbook voter.” Germany is recovering from the pandemic, which is marginally supportive for an otherwise faltering ruling party. However, the economic data is only good enough to suggest that the Union will not utterly collapse. A rise in unemployment, inflation, and the combination of the two (the “Misery Index”) is a tell-tale sign that the incumbent party will suffer a substantial defeat (Chart 7). However the German economy’s loss of momentum is temporary. Growth will re-accelerate in early 2022. The timing is politically inconvenient for the ruling party but positive news for investors. German economic confidence is deteriorating. The Ifo Business Climate survey has rolled over, lowered by a meaningful decline in the Expectations Survey. Additionally, consumer confidence is turning south, despite already being low (Chart 8). Chart 7Spike In German Misery Index A Tell-Tale Sign Of Poor Election For Incumbent Party Chart 8Deteriorating German Confidence A combination of factors weighs on German confidence: First, global supply chain bottlenecks are hurting growth. The automotive industry, which is paralyzed by a global chip shortage, accounts for about 20% of industrial production, and its output is once again declining after a sharp but short-lived rebound last year (Chart 9). Similarly, inventories of finished goods are collapsing, which is hurting growth today (Chart 9, second panel). Second, the Delta variant of COVID-19 is causing a spike in infections. The rise in cases prevents containment measures from easing as much as expected, while it also hurts the willingness of households to go out and spend their funds (Chart 9, third panel). Third, German real wages are weak. Negotiated wages are only growing at a 1.7% annual rate, and wages and salaries are expanding at 2.1% annually. Meanwhile, German headline CPI runs at 3.9%. The declining purchasing power of German households accentuates their current malaise. Three crucial forces counterbalance these negatives: First, German house prices are growing at a 9.4% annual rate, which is creating a potent, positive wealth effect (Chart 10). Chart 9Germany's Headwinds Chart 10A Strong Wealth Effect Second, German household credit remains robust. According to the Bundesbank, the strength in household credit mostly reflects the strong demand for mortgages. Historically, a healthy housing sector is an excellent leading indicator of economic vigor. Third, the Chinese credit impulse is too depressed for Beijing’s political security. The recent decline in the credit impulse to -2.4% of GDP reflects a policy decision in the fall of 2020 to trim down the credit expansion. As a result, Chinese economic growth is slowing. For example, both the Caixin Manufacturing and Services PMIs stand below 50, at post-pandemic lows of 49.2 and 46.7, respectively. In July authorities became uncomfortable and cut the Reserve Requirement Ratio as well as interbank rates to free liquidity and stabilize the economy. A boom is not forthcoming, but the drag on global activity will ebb by next year. Including the headwinds and tailwinds to the economy, German activity will slow down for the remainder of the year before improving anew in 2022. Our election case outlined above – that the conservatives will lose the chancellorship and either be excluded from power or greatly diminished in the Bundestag – means that fiscal policy will not be tightened abruptly and will not create a material risk to this outlook. Chart 11Vaccines Work Many of the headwinds will dissipate. The Delta-wave of COVID-19 will diminish. Already, Germany’s R0 is tentatively peaking, which normally precedes a drop in daily new cases. Moreover, Germany’s vaccination campaign is progressing, which limits the impact of the current wave on hospitalization and intensive care-unit usage (Chart 11). Inflation will peak in Germany, which will salvage real wages. As European Investment Strategy wrote last Monday,6 European inflation remains concentrated in sectors linked to commodity prices or directly affected by bottlenecks. Instead, trimmed-mean CPI is muted (Chart 12), which implies that underlying inflationary pressures are small, especially as wage gains are still well contained. Moreover, the one-off impact of the end of the German VAT rebate will also pass. Finally, a stabilization and eventual revival of the Chinese credit impulse will put a floor under German exports, industrial production, and capex (Chart 13). For now, the previous decline in the Chinese credit impulse is consistent with slower German output growth for the remainder of 2021. However, next year, the German industrial sector will start to feel the effect of the current efforts to improve Chinese liquidity conditions. Chart 12Narrow European Inflation Bottom Line: The German economy is set to deteriorate for the remainder of 2021. However, as the current wave of COVID-19 infections ebbs, real wages recover, and China’s credit impulse stabilizes, Germany’s economic activity will re-accelerate in 2022, especially if the upcoming election does not generate a meaningful fiscal shock. We do not think it will. Chart 13China: From Headwinds To Tailwind? Market Implications: German Stocks To Shine German equities are set to outperform their European counterparts and will significantly beat Bunds over the coming 18 months. During the past 5 months, the German MSCI index has underperformed the rest of the Eurozone by 6.2%. The poor performance of German equities is worse than meets the eye. If we adjust for sectoral differences by building equal sector-weight indexes, Germany has underperformed the Euro Area by 22% since early 2017 (Chart 14). Chart 14Not Delivering The Goods This underperformance is long in the tooth and should reverse because of four important dynamics. First, German equities are cheap relative to the European benchmark. As Chart 15 highlights, the relative performance of German stock prices has lagged that of profits. This underperformance is also true once we account for the different sectoral composition of the German market. As a result, Germany is cheap on a forward price-to-earnings, price-to-sales, and price-to-book basis versus the Euro Area. Additionally, analysts embed significantly lower long-term and one-year expected growth rates of earnings in Germany than in the rest of the Eurozone, which depresses the German PEG ratios. Second, German operating metrics do not justify the valuation discount of German equities. The return on equity of German stocks stands at 11.39%, which is similar to that of the Euro Area. Profit margins are also comparable, at 5.91% and 5.74%, respectively. However, German firms utilize their capital more efficiently, and their asset turnover stands at 0.3 times compared to 0.2 times for the Eurozone average. Meanwhile, German non-financial firms are less indebted than their Eurozone competitors, which implies that Germany’s return on assets is greater than that of Europe at large (Chart 16). Chart 15Lagging Prices, Not Earnings Chart 16Why The Discount? Third, the drivers of earnings support a German outperformance. Over the past thirty years, commodity prices led the performance of German stocks relative to that of the rest of the Eurozone (Chart 17). While the near-term outlook for natural resource prices is muddy, BCA’s commodity strategists expect Brent prices to average more than $80/bbl in 2023 and industrial metals to outperform energy over the coming years.7 Additionally, German Services PMI are bottoming compared to that of the Eurozone. Over the past decade, this process preceded periods of outperformance by German stocks (Chart 18). Similarly, the collapse in the Chinese credit impulse relative to the robust domestic economic activity in Europe is well reflected in the underperformance of German shares. The Eurozone’s Service PMI is near all-time highs and unlikely to improve further; however, the Chinese credit impulse should recover in the coming quarters. This phenomenon will help German stocks (Chart 19). Chart 17Commodity Bulls Pull Germany Chart 18German Vs European Activity Matters Chart 19German Vs Chinese Activity Matters The German MSCI index is also oversold. The 52-week rate of change of its performance compared to the rest of the Eurozone plunged to its lowest reading since the introduction of the euro in 1999 (Chart 20). Meanwhile, the 13-week rate of change remains low but has begun to improve (not shown). This combination usually heralds a forthcoming rebound in German relative performance. In relation to equities, German Bunds remain an unappealing investment. Based on historical experience, the current yield of -0.36% offered by German 10-year bonds condemns investors to negative returns over the next five years (Chart 21). Chart 20Oversold! Chart 21Bounded Bunds' Returns Even if realized inflation ebbs in Germany and Europe, inflation expectations remain low and an eventual return to full employment will force CPI swaps higher, especially if the ECB maintains easy monetary conditions and invites further risk-taking in the Eurozone. The global economic cycle will also move from a friend to a foe for Bunds. As Chart 22 illustrates, the recent deceleration in global export growth was consistent with the fresh uptick in the returns of German paper. However, if Chinese credit flows stabilize by year-end and reaccelerate in 2022 while supply-chain bottlenecks dissipate, global export growth will improve. This should hurt Bund prices, especially as the long-term terminal rate proxy embedded in the German curve remains too low. As a result, not only should Bunds underperform German equities, but the German yield curve will also steepen further relative to that of the US, where the Fed will lift the short-end of the curve faster than the ECB. Chart 22Economic Momentum And Bunds Prices Bottom Line: The underperformance of German equities relative to those of the rest of the Eurozone is well advanced, which makes German stocks a bargain. The current deceleration in global and German growth will not extend beyond 2021, which suggests that German stocks prices should converge toward their earnings outperformance next year. Our political forecast suggests that the odds of an early or aggressive fiscal retrenchment are very low. Additionally, German equities will outperform Bunds, which offer particularly poor prospective returns.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary Senior Vice President Mathieu@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Note that minority governments are rare and have a bad reputation in Germany, partly as a result of the series of weak governments leading up to the 1932 election and Nazi rule. 2 In addition, while the center-left parties can work with the far-left in the Bundestag, the center-right parties cannot work with the far-right Alternative for Germany. Indeed the slightest imputation of a willingness to work with Alternative for Germany cost Merkel’s first pick for successor, Annegret Kramp-Karrenbauer, her job. 3 See: Norpoth, Helmut & Gschwend, Thomas (2010) The chancellor model: Forecasting German elections, International Journal of Forecasting. 26. 42-53. 4 Our model performs well in back-testing but 2017 was an outlier. It correctly predicted the Union to win the highest share of the popular vote but overestimated that vote by seven percentage points. Our only short-term variable, the chancellor’s approval rate, caused a deviation from long-term voting trends. Our other two variables capture medium and long-term effects, which clearly favored the Union. The implication is that Merkel’s high approval rating today could give a misleading impression about the Christian Democrats’ prospects. 5 If they are forced to rely on the Free Democrats instead, that will also constrain the most anti-business elements of their agenda. 6 Please see BCA Research European Investment Strategy Weekly Report, "The ECB Taper Dilemma", dated September 6, 2021, available at eis.bcareseach.com. 7 Please see BCA Research Commodity & Energy Strategy Weekly Report, "Permian Output Approaches Pre-Covid Peak", dated August 19, 2021, available at ces.bcareseach.com.