Inflation

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Demand in the major economies remains well below its pre-pandemic trend. Meaning that relative to potential output, demand is lukewarm, at best. Inflation is hot, not because of strong overall demand, but because of the surging demand for goods. If the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Underweight personal goods versus consumer services. Bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market and the $100 trillion global equity market. Long-term investors should continue to own US T-bonds and focus their equity investments in long-duration (growth) stocks, sectors, and stock markets… …because the ultimate low in bond yields is yet to come. Feature Chart of the WeekWill Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? Will Bond Yields Stay Chilled With Inflation So Hot? 2022 begins with an investment conundrum. Why have long bond yields been so chilled when inflation is running so hot? (Chart I-1) While US and UK inflation have ripped to 6.9 percent and 5.1 percent respectively, the 30-year T-bond yield and 30-year gilt yield remain a relative oasis of calm – standing at 2.1 percent and 1.2 percent respectively. 10-year yields have also stayed relatively calm. Moreover, as long-duration bonds set the valuations of long-duration stocks, a calm bond market has meant a calm stock market. What can explain this apparent conundrum of chilled yields in the face of the hottest inflation in a generation? Long Bond Yields Are Tracking Demand, Not Inflation Chart I-2 answers the conundrum. The long bond yield is taking its cue not from hot inflation, but from economic demand, which is far from overheating. Quite the contrary, US real GDP and consumption are struggling to reach their pre-pandemic trends. Meanwhile, UK real GDP languishes 5 percent below its pre-pandemic trend (Chart I-3), and other major economies tell similar stories. Chart I-2Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Long Bond Yields Are Tracking Demand Chart I-3Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Demand Is Lukewarm, At Best Some people mistake the strong economic growth in recent quarters for overheating demand. In fact, this robust growth is just the natural snap-back after the pandemic induced collapse in early-2020. Meaning that the strong growth is unsustainable, just as the bounce that a ball experiences after a big drop is unsustainable. Demand in the major economies remains well below its pre-pandemic trend. To repeat, demand in the major economies remains well below its pre-pandemic trend. As this pre-pandemic trend is a good gauge of potential output, economic demand is lukewarm, at best. And this explains why long bond yields have remained chilled. Inflation Is Tracking The Displacement Of Demand Yet solving the first conundrum simply raises a second conundrum. If overall demand is lukewarm, then why is inflation so hot? (Chart I-4). The answer is that inflation is being fuelled by the displacement of demand into goods from services (Chart I-5). Chart I-4Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Hot Inflation Is Not Reflecting Lukewarm Overall Demand Chart I-5Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods Hot Inflation Is Reflecting The Hot Demand For Goods If a dollar spent on goods is displaced from a dollar spent on services, then overall demand will be unchanged. However, what happens to the overall price level depends on the relative price elasticities of demand for goods and services. If the price elasticities are the same, then overall prices will also be unchanged, because a higher price for goods will be exactly countered by a lower price for services. But if the price elasticities are very different, then overall prices can rise sharply because the higher price for goods will dominate overall inflation. All of which solves our second conundrum. Spending on services that require close contact with strangers – using public transport, going to the dentist, cinema, or recreational activities that involve crowds – are suffering severe shortfalls compared to pre-pandemic times. Some people say that this is due to supply shortages, yet the trains and buses are running empty and there is no shortage of dentists, cinema seats, or even (English) Premier League tickets. Indeed, the Premier League team that I support (which I will not name) has been sending me begging emails to attend matches! Surging inflation is no longer a reliable reflection of overall demand. If somebody doesn’t use public transport, or go to the cinema or crowded events because he is worried about the health risk, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In other words, the price elasticity of demand for certain services has flipped from its usual negative to zero, or even positive.   This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging inflation is no longer a reliable reflection of overall demand, which remains below its potential. Instead, surging inflation is largely reflecting the surging demand for goods. Two Ways That Inflation Can Resolve: One Good, One Bad It follows that if the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. We recommend that equity investors play this inevitable normalisation by underweighting personal goods versus consumer services. Still, the resolution of inflation could also take a ‘bad’ form. If inflation persisted, then bond yields could lose their chill as they flipped their focus from lukewarm demand to hot inflation. Given that long-duration bonds set the valuations of long-duration stocks, and given that stock valuations are already stretched versus bonds, this would quickly inflict pain on stock investors (Chart I-6). Chart I-6The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits More significantly, it would also quickly inflict pain on the all-important real estate market. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent1 (Chart I-7). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields (Chart I-8). Chart I-7The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion… The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion... Chart I-8…And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields ...And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields This means that bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, the massive deflationary backlash would annihilate any lingering inflation. Some people counter that in an inflationary shock, stocks and property – as the ultimate real assets – ought to perform well even as bond yields rise. However, when valuations start off stretched as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. The scope for higher bond yields is limited by the fragility of stock market and real estate valuations. With the scope for higher yields limited by the fragility of stock market and real estate valuations, and with the ultimate low in yields yet to come, long-term investors should continue to own US T-bonds. And they should focus their equity investments in long-duration (growth) stocks, sectors, and stock markets. Fractal Trading Update Owing to the holidays, we are waiting until next week to initiate new trades. We will also add a new feature – a ‘watch list’ of investments that are approaching potential turning points, but are not yet at peak fragility. We believe that this enhancement will help to prepare future trades. Stay tuned.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades Image 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​

Highlights 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? Will Services Spending Recover To Its Pre-Pandemic Trend? Will Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1.  How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 The Pandemic's Sine-Wave Will Propagate Into 2022 The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2.    Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Dental Services Are Far Below The Pre-Pandemic Trend Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend Physician Services Are Far Below The Pre-Pandemic Trend Physician Services Are Far Below The Pre-Pandemic Trend   Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Recreation Services Are Far Below The Pre-Pandemic Trend Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Public Transportation Is Far Below The Pre-Pandemic Trend Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-7). Image The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4.    How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Goods Prices Have Reacted To A Positive Demand Shock... Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock ...But Service Prices Have Not Reacted To A Negative Demand Shock ...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive.  This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5.    Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value Cryptocurrencies Will Continue To Displace Gold's Investment Value Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6.    How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Chart I-11 Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7.    Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Chart I-12 Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation Property Price Inflation Has Far Exceeded Rent Inflation Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits The US Stock Market = The 30-Year T-Bond Multiplied By Profits The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Underweight Commodities That Haven't Yet Corrected Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services Underweight Personal Goods Versus Consumer Services Underweight Personal Goods Versus Consumer Services   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 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 - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Dear Client, We are sending you our Strategy Outlook today where we outline our thoughts on the global economy and the direction of financial markets for 2022 and beyond. Next week, please join me for a webcast on Friday, December 10th at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) to discuss the outlook. Also, we published a report this week transcribing our annual conversation with Mr. X, a long-standing BCA client. Please join my fellow BCA strategists and me on Tuesday, December 7th for a follow-up discussion hosted by my colleague, Jonathan LaBerge. Finally, you will receive a Special Report prepared by our Global Asset Allocation service on Monday, December 13th. Similarly to previous years, Garry Evans and his team have prepared a list of books and articles to read over the holiday period. This year they recommend reading materials on key themes of the moment, such as climate change, cryptocurrencies, supply-chain disruption, and gene technology. Included in this report are my team’s recommendations on what to read to understand the underlying causes of inflation. Best regards, Peter Berezin, Chief Global Strategist   Highlights Macroeconomic Outlook: Despite the risks posed by the Omicron variant, global growth should remain above trend in 2022. Inflation will temporarily dip next year as goods prices come off the boil. However, the structural trend for inflation is to the upside, especially in the US. Equities: Remain overweight stocks in 2022, favoring cyclicals, small caps, value stocks, and non-US equities. Look to turn more defensive in mid-2023 in advance of a stagflationary recession in 2024 or 2025. Fixed income: Maintain below-average interest rate duration exposure. The US 10-year Treasury yield will rise to 2%-to-2.25% by the end of 2022. Underweight the US, UK, Canada, and New Zealand in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds next year. Favor HY over IG. Spreads will widen again in 2023. Currencies: As a momentum currency, the US dollar could strengthen some more over the next month or two. Over a 12-month horizon, however, the trade-weighted dollar will weaken. The Canadian dollar will be the best performing G10 currency next year. Commodities: Oil prices will rise, with Brent crude averaging $80/bbl in 2022. Metals prices will remain resilient thanks to tight supply and Chinese stimulus. We prefer gold over cryptos. I. Macroeconomic Outlook   Running out of Greek Letters Just as the world was looking forward to “life as normal”, a new variant of the virus has surfaced. While little is known about the Omicron variant, preliminary indications suggest that it is more transmissible than Delta. The emergence of the Omicron variant is coming in the midst of yet another Covid wave. The number of new cases has skyrocketed across parts of northern and central Europe, prompting governments to re-introduce stricter social distancing measures (Chart 1). New cases have also been trending higher in many parts of the US and Canada since the start of November. Chart 1 Despite the risks posed by Omicron, there are reasons for hope. BioNTech has said that its vaccine, jointly developed with Pfizer, will provide at least partial immunity against the new strain. At present, 55% of the world’s population has had at least one vaccine shot; 44% is fully vaccinated (Chart 2). China is close to launching its own mRNA vaccine next year, which it intends to administer as a booster shot. Chart 2 In a worst-case scenario, BioNTech has said that it could produce a new version of its vaccine within six weeks, with initial shipments beginning in about three months. New antiviral medications are also set to hit the market. Pfizer claims its newly developed pill cuts the risk of hospitalization by nearly 90% if taken within three days from the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. In addition, it is allowing generic versions to be manufactured in developing countries. The company has indicated that its antiviral pills will be effective in treating the new strain.   Global Growth: Slowing but from a High Level Assuming the vaccines and antiviral drugs are able to keep the new strain at bay, global growth should remain solidly above trend in 2022. Table 1 shows consensus GDP growth projections for the major economies. G7 growth is expected to tick up from 3.6% in 2021Q3 to 4.5% in 2021Q4. Growth is set to cool to 4.1% in 2022Q1, 3.6% in 2022Q2, 2.9% in 2022Q3, 2.3% in 2022Q4, and 2.1% in 2023Q1. Table 1Growth Is Slowing, But From Very High Levels Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Chart 3 According to the OECD, potential real GDP growth in the G7 is about 1.4% (Chart 3). Thus, while growth in developed economies will slow next year, it is unlikely to return to trend until the second half of 2023. Emerging markets face a more daunting outlook. The Chinese property market is weakening, and the recent collapse of the Turkish lira highlights the structural problems that some EMs face. Nevertheless, the combination of elevated commodity prices, forthcoming Chinese stimulus, and the resumption of the US dollar bear market starting next year should support EM growth. Relative to consensus, we think the risks to growth in both developed and emerging markets are tilted to the upside in 2022. Growth will likely start surprising to the downside in late 2023, however.   The United States: No Shortage of Demand US growth slowed to only 2.1% in the third quarter, reflecting the impact of the Delta variant wave and supply-chain bottlenecks. The semiconductor shortage hit the auto sector especially hard. The decline in vehicle spending alone shaved 2.2 percentage points off Q3 GDP growth. Chart 4Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up The fourth quarter is shaping up to be much stronger. The Bloomberg consensus estimate is for real GDP to expand by 4.9%. The Atlanta Fed’s GDPNow model is even more optimistic. It sees growth hitting 9.7%. The demand for goods will moderate in 2022. As of October, real goods spending was still 10% above its pre-pandemic trendline (Chart 4). In contrast, the demand for services will continue to rebound. While restaurant sales have recovered all their lost ground, spending on movie theaters, amusement parks, and live entertainment in October was still down 46% on a seasonally-adjusted basis compared to January 2020. Hotel spending was down 23%. Spending on public transport was down 25%. Spending on dental services was down 16% (Chart 5).   Chart 5 US households have accumulated $2.3 trillion in excess savings over the course of the pandemic. Some of this money will be spent over the course of 2022 (Chart 6). Increased borrowing should also help. After initially plunging during the pandemic, credit card balances are rising again (Chart 7). Banks are eager to make consumer loans (Chart 8). Chart 6Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 7Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 9). In an earlier report, we estimated that the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 9A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Business investment will rebound in 2022, as firms seek to build out capacity, rebuild inventories, and automate more production in the face of growing labor shortages. After moving sideways for the better part of two decades, core capital goods orders have broken out to the upside. Surveys of capex intentions have improved sharply (Chart 10). Nonresidential investment was 6% below trend in Q3 – an even bigger gap than for consumer services spending – so there is plenty of scope for capex to increase. Residential investment should also remain strong in 2022 (Chart 11). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 6-month high in November. Building permits are 7% above pre-pandemic levels. Chart 10Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 11Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported   US Monetary and Fiscal Policy: Baby Steps Towards Tightening Policy is unlikely to curb US aggregate demand by very much next year. While the Federal Reserve will expedite the tapering of asset purchases and begin raising rates next summer, the Fed is unlikely to raise rates significantly until inflation gets out of hand. As we discuss in the Feature section later in this report, the next leg in inflation will be to the downside, even if the long-term trend for inflation is to the upside. The respite from inflation next year will give the Fed some breathing space. A major tightening campaign is unlikely until mid-2023. Reflecting the Fed’s dovish posture, long-term real bond yields hit record low levels in November (Chart 12). Despite giving up some of its gains in recent days, Goldman’s US Financial Conditions Index stands near its easiest level in history (Chart 13). Chart 12US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows Chart 13Easy Financial Conditions In The US Easy Financial Conditions In The US Easy Financial Conditions In The US US fiscal policy will get tighter next year, but not by very much. In November, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. The emergence of the Omicron strain will facilitate passage of the bill because it will allow the Democrats to add some “indispensable” pandemic relief to the package. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 14). Chart 14 It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 15). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks. Chart 15While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend Chart 16European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act Europe: Room to Grow The European economy faces near-term growth pressures. In addition to Covid-related lockdowns, high energy costs will take a bite out of growth. After having dipped in October, natural gas prices have jumped again due to delays in the opening of the Nord Stream 2 pipeline, strong Chinese gas demand, and rising risks of a colder winter due to La Niña. The majority of Germans are in favor of opening the pipeline, suggesting that it will ultimately be approved. This should help reduce gas prices. Meanwhile, the winter will pass and Chinese demand for gas should abate as domestic coal production increases. The combination of increased energy supplies, easing supply-chain bottlenecks, and hopefully some relief on the pandemic front, should all pave the way for better-than-expected growth across the euro area next year. After a decade of housecleaning, European banks are in much better shape (Chart 16). Capex intentions have risen (Chart 17). Consumer confidence is even stronger in the euro area than in the US (Chart 18). Chart 17 Chart 18Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Euro area fiscal policy should remain supportive. Infrastructure spending is set to increase as the Next Generation EU fund begins operations. Germany’s “Traffic Light” coalition will pursue a more expansionary fiscal stance. The IMF expects the euro area to run a cyclically-adjusted primary deficit of 1.2% of GDP between 2022 and 2026, compared to a surplus of 1.2% of GDP between 2014 and 2019. For its part, the ECB will maintain a highly accommodative monetary policy. While net asset purchases under the PEPP will end next March, the ECB is unlikely to raise rates until 2023 at the earliest. In contrast to the US, trimmed-mean inflation has barely risen in the euro area (Chart 19). Moreover, unlike their US counterparts, European firms are reporting few difficulties in finding qualified workers (Chart 20). In fact, euro area wage growth slowed to an all-time low of 1.35% in Q3 (Chart 21). Chart 19Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Chart 20   Chart 21Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area The UK finds itself somewhere between the US and the euro area. Trimmed-mean inflation is running above euro area levels, but below that of the US. UK labor market data remains very strong, as evidenced by robust employment gains, firm wage growth, and a record number of job vacancies. The PMIs stand at elevated levels, with the new orders component of November’s manufacturing PMI rising to the highest level since June. While worries about the impact of the Omicron variant will likely cause the Bank of England to postpone December’s rate hike, we expect the BoE to begin raising rates in February.   Japan: Short-Term Stimulus Boost A major Covid wave during the summer curbed Japanese growth. Consumer spending rebounded after the government removed the state of emergency on October 1 but could falter again if the Omicron variant spreads. The government has already told airlines to halt reservations for all incoming international flights for at least one month. On the positive side, the economy will benefit from new fiscal measures. Following the election on October 31, the new government led by Prime Minister Fumio Kishida announced a stimulus package worth 5.6% of GDP. As with most Japanese stimulus packages, the true magnitude of fiscal support will be much lower than the headline figure. Nevertheless, the combination of increased cash payments to households, support for small businesses, and subsidies for domestic travel should spur consumption in 2022. The capex recovery in Japan has lagged other major economies. This is partly due to the outsized role of the auto sector in Japan’s industrial base. Motor vehicle shipments fell 37% year-over-year in October, dragging down export growth with it. As automotive chip supplies increase, Japan’s manufacturing sector should gain some momentum. Despite the prospect of stronger growth next year, the Bank of Japan will stand pat. Core inflation remains close to zero, while long-term inflation expectations remain far below the BOJ’s 2% target. We do not expect the BOJ to raise rates until 2024 at the earliest.   China: Crosswinds The Chinese economy faces crosswinds going into 2022. On the one hand, the energy crisis should abate, helping to boost growth. China has reopened 170 coal mines and will probably begin re-importing Australian coal. Chinese coal prices have fallen drastically over the past 6 weeks (Chart 22). Coal accounts for about two-thirds of Chinese electricity generation. Chart 22Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 23China's Property Market Has Weakened China's Property Market Has Weakened China's Property Market Has Weakened   The US may also trim tariffs on Chinese goods, as Treasury Secretary Yellen hinted this week. This will help Chinese manufacturers. On the other hand, the property market remains under stress. Housing starts, sales, and land purchases were down 34%, 21%, and 24%, respectively, in October relative to the same period last year. The proportion of households planning to buy a home has plummeted. Loan growth to real estate developers has decelerated to the lowest level on record (Chart 23). Nearly half of their offshore bonds are trading at less than 70 cents on the dollar. The authorities have taken steps to stabilize the property market. They have relaxed restrictions on mortgage lending and land sales, cut mortgage rates in some cities, and have allowed some developers to issue asset backed securities to repay outstanding debt. Most Chinese property is bought “off-plan”. The government does not want angry buyers to be deprived of their property. Thus, the existing stock of planned projects will be built. Chart 24 shows that this is a large number; in past years, developers have started more than twice as many projects as they have completed. The longer-term problem is that China builds too many homes. Like Japan in the early 1990s, China’s working-age population has peaked (Chart 25). According to the UN, it will decline by over 400 million by the end of the century. China simply does not need to construct as many new homes as it once did. Chart 24Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chart 25Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Chart 26 Japan was unable to fill the gap that a shrinking property sector left in aggregate demand in the early 1990s. As a result, the economy fell into a deflationary trap. China is likely to have more success. Unlike Japan, which waited too long to pursue large-scale fiscal stimulus, China will be more aggressive. The authorities will raise infrastructure spending next year with a focus on clean energy. They will also boost social spending. A frayed social safety net has forced Chinese households to save more than they would otherwise for precautionary reasons. This has weighed on consumption.  The fact that China is a middle-income country helps. In 1990, Japan’s output-per-worker was nearly 70% of US levels; China’s output-per-worker is still 20% of US levels (Chart 26). If Chinese incomes continue to grow at a reasonably brisk pace, this will make it easier to improve home affordability. It will also allow China to stabilize its debt-to-GDP ratio without a painful deleveraging campaign. II. Feature: The Long-Term Inflation Outlook   Two Steps Up, One Step Down We expect inflation in the US, and to a lesser degree abroad, to follow a “two steps up, one step down” trajectory of higher highs and higher lows. The US is currently near the top of those two steps. Inflation should dip over the next 6-to-9 months as the demand for goods moderates and supply-chain disruptions abate. Chart 27 shows that container shipping costs have started to come down. The number of ships anchored off the ports of Los Angeles and Long Beach is falling. US semiconductor firms are working overtime (Chart 28). Chip production in Japan and Korea is rising swiftly. DRAM chip prices have already started to decline. Chart 27Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Chart 28Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Reflecting the easing of supply-chain bottlenecks, both the “prices paid” and “supplier delivery” components of the manufacturing ISM declined in November.  The respite from inflation will not last long, however. The US labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 29). Wage growth will broaden out over the course of 2022, pushing up service price inflation in the process. Chart 29Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Chart 30Rent Inflation Has Increased Rent Inflation Has Increased Rent Inflation Has Increased Rent inflation will also rise, as the unemployment rate falls further. The Zillow rent index has spiked 14% (Chart 30). Rents account for 8% of the US CPI basket and 4% of the PCE basket.   Biased About Neutral? Investors are assuming that the Fed will step in to extinguish any inflationary fires before they get out of hand. The widely-followed 5-year/5-year forward TIPS breakeven inflation rate has fallen back below the Fed’s comfort zone (Chart 31). Chart 31Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Chart 32Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate This may be wishful thinking. Back in 2012, when the Fed began publishing its “dots”, it thought the neutral rate of interest was 4.25%. Today, it considers it to be around 2.5% (Chart 32). Market participants broadly agree. Both investors and policymakers have bought into the secular stagnation thesis hook, line, and sinker. If the neutral rate turns out to be higher than widely believed, the Fed could find itself woefully behind the curve. Given the “long and variable” lags between changes in monetary policy and the resulting impact on the economy, inflation is liable to greatly overshoot the Fed’s target.   Structural Forces Turning More Inflationary Meanwhile, the forces that have underpinned low inflation over the past few decades are starting to fray: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 33). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. Baby boomers are leaving the labor force en masse: As a group, baby boomers hold more than half of US household wealth (Chart 34). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Spending that is not matched by output tends to drive up inflation. Chart 33Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Chart 34 Social stability is in peril: The US homicide rate increased by 27% in 2020, the biggest one-year jump on record. All indications suggest that crime has continued to rise in 2021, coinciding with the ongoing decline in the incarceration rate (Chart 35). Amazingly, the murder rate and inflation are highly correlated (Chart 36). If the government cannot credibly commit to keeping people safe, how can it credibly commit to keeping inflation low? Without trust in government, inflation expectations could quickly become unmoored. Chart 35The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined Chart 36Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime The temptation to monetize debt will rise: Public-sector debt levels have soared to levels last seen during World War II. If bond yields rise as the Congressional Budget Office expects, debt-servicing costs will triple by the end of the decade (Chart 37). Faced with the prospect of having to divert funds from social programs to pay off bondholders, the government may apply political pressure on the Fed to keep rates low.​​​​​​ Chart 37   A Post-Pandemic Productivity Boom? Chart 38 Might faster productivity growth bail out the economy just like it did following the Second World War? Don’t bet on it. US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects that saw many low-skilled, poorly-paid service workers lose their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. Productivity growth has been extremely weak outside the US (Chart 38). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is worth noting that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. However, the near-term impact of higher capex will be to boost aggregate demand, stoking inflation in the process. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Our golden rule of investing is about as simple as they come: Don’t bet against stocks unless you think that there is a recession around the corner. As Chart 39 shows, recessions and equity bear markets almost always overlap. Chart 39 Chart 40Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Equity corrections can occur outside of recessionary periods. In fact, we are experiencing such a correction right now. Yet, with the percentage of bearish investors reaching the highest level in over 12 months in this week’s AAII survey, chances are that the correction will not last much longer (Chart 40). A sustained decline in stock prices requires a sustained decline in corporate earnings; the latter normally only happens during economic downturns. Admittedly, it is impossible to know for sure if a recession is lurking around the corner. If the Omicron variant is able to completely evade the vaccines, growth will slow considerably over the coming months. Yet, even in that case, the global economy is unlikely to experience a sudden-stop of the sort that occurred last March. As noted at the outset of this report, pharma companies have the tools to tweak the vaccines, and most experts believe that the soon-to-be-released antivirals will be effective against the new strain. If economic growth remains above trend, earnings will rise (Chart 41). S&P 500 companies generated $53.82 per share in profits in Q3. The bottom-up consensus is for these companies to generate an average of $54.01 in quarterly profits between 2021Q4 and 2022Q3, implying almost no growth from 2021Q3 levels. This is a very low bar to clear. We expect global equities to produce high single-digit returns next year. Chart 41Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year The Beginning of the End Our guess is that 2022 will be the last year of the secular equity bull market that began in 2009. In mid-2023 or so, the Fed will come around to the view that the neutral rate is higher than it once thought. Unfortunately, by then, it will be too late; a wage-price spiral will have already emerged. A nasty bear flattening of the yield curve will ensue: Long-term bond yields will rise but short-term rate expectations will increase even more. A recession will follow in 2024 or 2025. The most important real-time indicator we are focusing on to gauge when to turn more bearish on stocks is the 5y/5y forward TIPS breakeven rate. As noted earlier, it is still at the bottom end of the Fed’s comfort zone. If it were to rise above 3%, all hell could break loose, especially if this happened without a corresponding increase in crude oil prices. The Fed takes great pride in the success it has had in anchoring long-term expectations. Any evidence that expectations are becoming unmoored would cause the FOMC to panic.   B. Equity Sectors, Regions, And Styles Favor Value, Small Caps, and Non-US Markets in 2022 Until the Fed takes away the punch bowl, a modestly procyclical stance towards equity sectors, styles, and regional equity allocation is warranted. Chart 42The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The relative performance of value versus growth stocks has broadly followed the trajectory of the 30-year Treasury yield this year (Chart 42). Rising yields should buoy value stocks, with banks being the biggest beneficiaries (Chart 43). In contrast, rising yields will weigh on tech stocks. Chart 43Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks   Chart 44The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves If we receive some good news on the pandemic front, this should disproportionately help value. As Chart 44 illustrates, the relative performance of value versus growth stocks has tracked the number of new Covid cases globally. The correlation between new cases and the relative performance of IT and energy has been particularly strong. Rising capex spending will buoy industrial stocks. Industrials are overrepresented in value indices both in the US and abroad (Table 2). Along with financials, industrials are also overrepresented in small cap indices (Table 3). US small caps trade at 15-times forward earnings compared to 21-times for the S&P 500. Table 2Breaking Down Growth And Value By Sector Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Table 3Financials And Industrials Have A Larger Weight In US Small Caps Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Time to Look Abroad? Given our preference for cyclicals and value in 2022, it stands to reason that we should also favor non-US markets. Table 4 shows that non-US stock markets have more exposure to cyclical and value sectors. Table 4Cyclicals Are Overrepresented Outside The US Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Admittedly, favoring non-US stock markets has been a losing proposition for the past 12 years. US earnings have grown much faster than earnings abroad over this period (Chart 45). US stock returns have also benefited from rising relative valuations. Chart 45The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years At this point, however, US stocks are trading at a significant premium to their overseas peers, whether measured by the P/E ratio, price-to-book, or price-to-sales (Chart 46). US profit margins are also more stretched than elsewhere (Chart 47).   Chart 46 Chart 47US Profit Margins Look Stretched US Profit Margins Look Stretched US Profit Margins Look Stretched Chart 48Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening The US dollar may be the ultimate arbiter of whether the US or international stock markets outperform in the 2022. Historically, there has been a close correlation between the trade-weighted dollar and the relative performance of US versus non-US equities (Chart 48). In general, non-US stocks do best when the dollar is weakening. The usual relationship between the dollar and the relative performance of US and non-US stocks broke down in 2020 when the dollar weakened but the tech-heavy US stock market nonetheless outperformed. However, if “reopening plays” gain the upper hand over “pandemic plays” in 2022, the historic relationship between the dollar and US/non-US returns will reassert itself. As we discuss later on, while near-term momentum favors the dollar, the greenback is likely to weaken over a 12-month horizon. This suggests that investors should look to increase exposure to non-US stocks in a month or two. Around that time, the energy shortage gripping Europe will begin to abate, China will be undertaking more stimulus, and investors will start to focus more on the prospect of higher US corporate taxes.    C. Fixed Income Maintain Below-Benchmark Duration The yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium that compensates investors for locking in their savings at a fixed rate rather than rolling them over at the prevailing short-term rate. While expected policy rates have moved up in the US over the past 2 months, the market’s expectations of where policy rates will be in the second half of the decade have not changed much (Chart 49). Investors remain convinced of the secular stagnation thesis which postulates that the neutral rate of interest is very low. Chart 49 As for the term premium, it remains stuck in negative territory, much where it has been for the past 10 years (Chart 50). Chart 50Negative Term Premium Across The Board Negative Term Premium Across The Board Negative Term Premium Across The Board The Term Premium Will Increase The notion of a negative term premium may seem odd, as it implies that investors are willing to pay to take on duration risk. However, there is a good reason for why the term premium has been negative: The correlation between bond yields and stock prices has been positive (Chart 51). Chart 51Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated When bond yields are positively correlated with stock prices, bonds are a hedge against bad economic news. If the economy falls into recession, equity prices will drop; the value of your home will go down; you may not get a bonus, or even worse, you may lose your job. But at least the value of your bond portfolio will go up! There is a catch, however: Bonds are a hedge against bad economic news only if that news is deflationary in nature. The 2001 and 2008-09 recessions all saw bond yields drop as the economy headed south. Both recessions were due to deflationary shocks: first the dotcom bust, and later, the bursting of the housing bubble. In contrast, bond yields rose in the lead up to the recession in the 1970s and early 80s. Bonds were not a good hedge against falling stock prices back then because it was surging inflation and rising bond yields that caused stocks to fall in the first place. This raises a worrying possibility that investors have largely overlooked: The term premium may increase as it becomes increasingly clear that the next recession will be caused not by inadequate demand but by Fed tightening in response to an overheated economy. A rising term premium would exacerbate the upward pressure on bond yields stemming from higher-than-expected inflation as well as upward revisions to estimates of the real neutral rate of interest. Again, we do not think that a “term premium explosion” is a significant risk for 2022. However, it is a major risk for 2023 and beyond. Investors should maintain a modestly below-benchmark duration stance for now but look to go maximally underweight duration towards the end of next year.   Global Bond Allocation BCA’s global fixed-income strategists recommend underweighting the US, Canada, the UK, and New Zealand in 2022. They suggest overweighting Japan, the euro area, and Australia. US Treasuries trade with a higher beta than most other government bond markets (Chart 52). Our bond strategists expect the US 10-year Treasury yield to hit 2%-to-2.25% by the end of next year. Chart 52High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields As discussed earlier, neither the ECB nor the BoJ are in a hurry to raise rates. Both euro area and Japanese bonds have outperformed the global benchmark when Treasury yields have risen (Chart 53). Chart 53 Chart 54UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies While rate expectations in Australia have come down on the Omicron news, the markets are still pricing in four hikes next year. With wage growth still below the RBA’s target, our fixed-income strategists think the central bank will pursue a fairly dovish path next year. In contrast, they think New Zealand will continue its hiking cycle. Like Canada, the Reserve Bank of New Zealand has become increasingly concerned about soaring home prices and household indebtedness.  Inflation expectations are higher in the UK than elsewhere (Chart 54). With the BoE set to raise rates early next year, gilts will underperform the global benchmark.   Overweight High-Yield Corporate Bonds… For Now Chart 55High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% The combination of above-trend economic growth and accommodative monetary policy will provide support for corporate bonds in 2022. For now, we prefer high yield over investment grade. According to our bond strategists, while high-yield spreads are quite tight, they are still pricing in a default rate of 3.8% (Chart 55). This is more than their fair value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.7%.   As with equities, the bull market in corporate credit will end in 2023 as the Fed is forced to accelerate the pace of rate hikes in the face of an overheated economy and rising long-term inflation expectations.   D. Currencies and Commodities Dollar Strength Will Reverse in Early 2022 Since bottoming in May, the US dollar has been trending higher. The US dollar is a high momentum currency: When the greenback starts rising, it usually keeps rising (Chart 56). A simple trading rule that buys the dollar when it is trading above its various moving averages has delivered positive returns (Chart 57). This suggests that the greenback could very well strengthen further over the next month or two. Chart 56 Chart 57 Over a 12-month horizon, however, we think the trade-weighted dollar will weaken. Both speculators and asset managers are net long the dollar (Chart 58). Current positioning suggests we are nearing a dollar peak. Rising US rate expectations have helped the dollar this year. Chart 59 shows that both USD/EUR and USD/JPY have tracked the spread between the yield on the December 2022 Eurodollar and Euribor/Euroyen contracts, respectively. While the Fed will expedite the pace of tapering, the overall approach will still be one of “baby-steps” towards tightening next year. BCA’s bond strategists do not expect US rate expectations for end-2022 to rise from current levels. Chart 58Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Chart 59Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year   The present level of real interest rate differentials is consistent with a much weaker dollar (Chart 60). Using CPI swaps as a proxy for expected inflation, 2-year real rates in the US are 42 basis points below other developed economies. This is similar to where real spreads were in 2013/14, when the trade-weighted dollar was 16% weaker than it is today. Chart 60AThe Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) Chart 60BThe Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) Meanwhile, growth outside the US will pick up next year as Europe’s energy crisis abates and China ramps up stimulus. If history is any guide, firmer growth abroad will put downward pressure on the dollar (Chart 61). Chart 61The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World Chart 62Dollar Headwinds Dollar Headwinds Dollar Headwinds Pricey Greenback The dollar’s lofty valuation has left it overvalued by nearly 20% on a Purchasing Power Parity (PPP) basis. The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply. Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 62). However, these inflows are starting to abate, and could drop further if global investors abandon their infatuation with US tech stocks.   Favor Commodity Currencies We favor commodity currencies for 2022, especially the Canadian dollar, which we expect to be the best performing G10 currency. Canadian real GDP growth will average nearly 5% in Q4 and the first half of next year. The Bank of Canada will start hiking rates next April. Oil prices should remain reasonably firm next year, helping the loonie and other petrocurrencies. Bob Ryan, BCA’s chief Commodity Strategist, expects the price of Brent crude to average $80/bbl in 2022 and 81$/bbl in 2023, which is well above the forwards (Chart 63). Years of underinvestment in crude oil production have led to tight supply conditions (Chart 64). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Chart 63 Chart 64   As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by Chinese fiscal stimulus. Looking further ahead, the outlook for metals remains bright. Whereas the proliferation of electric vehicles is bad news for oil demand over the long haul, it is good news for many metals. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   The RMB Will Be Stable in 2022 It is striking that despite the appreciation in the trade-weighted dollar since June and escalating concerns about the health of the Chinese economy, the RMB has managed to strengthen by 0.3% against the US dollar. Chinese export growth will moderate in 2022 as global consumption shifts from goods to services. Rising global bond yields may also narrow the yield differential between China and the rest of the world. Nevertheless, we doubt the RMB will weaken very much. China wants the RMB to be a global reserve currency. A weak RMB would run counter to that goal. Rather than weakening the yuan, the Chinese authorities will use fiscal stimulus to support growth.   Gold Versus Cryptos? Gold prices tend to move closely with real bond yields (Chart 65). Since August 2020, however, the price of gold has slumped from a high of $2,067/oz to $1,768/oz, even though real yields remain near record lows. The divergence between real yields and gold prices may partly reflect growing demand for cryptocurrencies. Investors increasingly see cryptos as not just a disruptive economic force, but as the premier “anti-fiat” hedge. Whether that view pans out remains to be seen. So far, the vast majority of the demand for cryptocurrencies has stemmed from people hoping to get rich by buying cryptos. To the extent that people are using cryptos for online purchases, it is usually for illegal goods (Chart 66).  Chart 65Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Chart 66 Crypto proponents like to say that the supply of cryptos is finite. While this may be true for individual cryptocurrencies, it is not true for the sector as a whole. Over the past 8 years, the number of cryptocurrencies has swollen from 26 in 2013 to 7,877 (Chart 67). At least with gold, they are not adding any new elements to the periodic table. Chart 67 At any rate, the easy money in the crypto space has already been made. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.2 trillion, equal to the entire stock of US dollars in circulation. Investors looking to hedge long-term inflation risk should shift back into gold. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Long-term investors should place up to 5 percent of their assets in cryptocurrencies. As the drawdown risk of owning cryptocurrencies converges with that of owning gold, the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market… … with BTC, ETH, and the others taking a third of this half – $2 trillion – each. This means that BTC would double to $120,000, while ETH would quadruple to $17,000. Some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. Underweight gold relative to the other precious metals. As cryptocurrencies eat more of gold’s lunch, gold is set to become a pale shadow of its former self. Fractal analysis: Coffee and Cameco. Feature Chart of the WeekCryptos Are Eating Gold's Lunch... And There's Plenty More To Eat Cryptos Are Eating Gold's Lunch... And There's Plenty More To Eat Cryptos Are Eating Gold's Lunch... And There's Plenty More To Eat If you’re wondering just how the market value of cryptocurrencies has surged to $2.5 trillion today from $0.5 trillion barely eighteen months ago, there’s a simple answer. Cryptocurrencies have eaten gold’s lunch – displacing almost $2 trillion from the investment value of the yellow metal. And that’s just so far… Given that the investment value of gold still stands at $9.5 trillion, there is plenty more of gold’s lunch that cryptocurrencies can eat (Chart of the Week). As Mark Twain might put it, rumours of crypto’s demise have been greatly exaggerated. When cryptocurrency prices corrected by 50 percent in May this year, the obituary writers got busy. For the 419th time. But since their birth in 2007, every time that they have ‘died’, cryptocurrencies have proved their detractors wrong, with prices quickly resurrecting and reaching new highs. We expect this pattern to continue (Chart I-2). Chart I-2Rumours Of Crypto's Demise Have Been Greatly Exaggerated Rumours Of Crypto's Demise Have Been Greatly Exaggerated Rumours Of Crypto's Demise Have Been Greatly Exaggerated Cryptocurrencies And Blockchains Are Joined At The Hip To understand the investment case for cryptocurrencies, it is important to realise that the success of a cryptocurrency and the success of its blockchain are inextricably linked. Yet what confuses this matter is that for the best known cryptocurrency of all – Bitcoin – the relationship between the cryptocurrency and its blockchain is ‘back-to-front’. Bitcoin is first and foremost a cryptocurrency BTC, which is secured (against double-spending) by its blockchain network. Meaning that BTC is the main act, and the Bitcoin blockchain is the supporting act. However, for most other cryptocurrencies, the opposite is true. The blockchain is the main act, and the cryptocurrency is the supporting act. For example, Ethereum is first and foremost a blockchain network – a decentralised intermediator of services such as smart-contracts or bond-issuance through decentralised finance (DeFi). Note that over $5 billion of bonds have already been issued on Ethereum and other blockchains, including by the European Investment Bank, the World Bank, and the Bank of China. The users of the Ethereum intermediation services pay the users of Ethereum that validate them in its cryptocurrency, ETH. Crucially, this ability to exchange ETH (and other cryptocurrencies) for intermediation services on the associated blockchain gives the cryptocurrency an economic utility. This economic utility means that the cryptocurrencies of successful blockchain networks can be thought of as ‘digital gold’. Gold derives its utility from its physical attributes – beauty, wear-ability, and electrical conductivity. Whereas, the cryptocurrencies of successful blockchains derive their utility from their means of exchange for the useful intermediation services that the blockchains provide. Furthermore, just as governments and central banks cannot determine the supply of gold, neither can they determine the supply of successful cryptocurrencies. This last point is important because most of the current value of gold comes not from its beauty, wear-ability, and electrical conductivity, but from its investment value as a hedge against the debasement of fiat money. The immediate investment case for cryptocurrencies is that they are set to displace much of this investment value from gold (Chart I-3). Chart I-3Cryptocurrencies Are Displacing Gold's Investment Value Cryptocurrencies Are Displacing Gold's Investment Value Cryptocurrencies Are Displacing Gold's Investment Value Cryptocurrencies Are Displacing Gold As The Anti-Fiat Hedge. Gold is scarce, but we can quantify its scarcity. Geology tells us that, in the earth’s crust, gold is 15 times as scarce as silver. And chemistry tells us that gold sits directly beneath silver in group 11 of the periodic table, meaning that the chemistry to extract gold and silver from their ores is essentially the same. Therefore, based on the geology and chemistry of the precious metals, gold should trade at around 15 times the price of silver. And 15 times the price of silver is precisely where gold did trade for centuries, and broadly where it traded in 1970. Yet by the mid-1970s the gold-to-silver ratio had breached 45, and by the late-1980s it had breached 75, where it stands today (Chart I-4). Why? Chart I-4Gold’s Massive Premium Versus Its Geological And Chemical Fundamentals Comes From Its Investment Value (As A Hedge Against The Debasement Of Fiat Money) Gold's Massive Premium Versus Its Geological And Chemical Fundamentals Comes From Its Investment Value Gold's Massive Premium Versus Its Geological And Chemical Fundamentals Comes From Its Investment Value The gold-to-silver ratio surged because, in 1971, the Bretton Woods ‘pseudo gold standard’ collapsed and the world economy moved to a fiat monetary system. Lest there is any doubt, a similar surge happened forty years earlier in 1931 when the original gold standard collapsed, before being reconstructed at the Bretton Woods conference in 1944. From these two surges, we can deduce that the premium in gold’s value versus its geological and chemical fundamentals constitutes its insurance policy value against the debasement of fiat money. Some people counter that only a small proportion of gold is owned as an explicit investment, and a large proportion is owned for its beauty and status. Yet this has been the case for millennia, and through most of this history gold-to-silver has traded in line with its geological and chemical fundamentals. Given that the gold price surges post-1931 and post-1971 coincided almost precisely with the introduction of fiat money, it is gold’s insurance policy value against the debasement of fiat money that is setting most of its current value. Based on the gold-to-silver ratio of 75 versus the geological and chemical fundamental value of 15, we can deduce that around four-fifths of gold’s $12 trillion above ground market value, or $9.5 trillion, comes from its insurance policy value. Add to that the current $2.5 trillion value of cryptocurrencies, and we can estimate that the total ‘anti-fiat’ investment market is worth $12 trillion. Of which, gold comprises around 80 percent, and cryptocurrencies around 20 percent. But to repeat, cryptocurrencies can eat much more of gold’s lunch (Chart I-5). Chart I-5Cryptocurrencies Can Eat Much More Of Gold's Lunch Cryptocurrencies Can Eat Much More Of Gold's Lunch Cryptocurrencies Can Eat Much More Of Gold's Lunch The Investment Implications: Bitcoin To $120,000, Ethereum To $17,000 We estimate that absent the displacement of investment value into cryptocurrencies since mid-2020, gold would now be trading at an all-time high of $2150 instead of at $1800. But given that there is much more of gold’s lunch for cryptocurrencies to eat, gold is set to become a pale shadow of its former self. Investors should underweight gold relative to the other precious metals. One pushback we get is that governments will ultimately issue a blanket ban on cryptocurrencies. But our pushback to the pushback is that it is a contradiction to be pro-blockchain and the anti- the ‘joined at the hip’ cryptocurrency which secures and validates the transactions on that blockchain. To resolve this contradiction, governments will try and regulate, rather than ban, cryptocurrencies. Another obvious question is: if Bitcoin is ‘back-to-front’ with its underlying blockchain having less utility and versatility than Ethereum and most other cryptocurrencies, should we still own BTC? The answer is yes, for two reasons. First, in time, the Bitcoin blockchain is likely to become more versatile; second, there will be some investors who hold out for the very long-term possibility that a cryptocurrency does displace fiat money. In which case, BTC would be the prime candidate. As the drawdown risk of owning cryptocurrencies converges with that of owning gold (Chart I-6), the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market, with BTC, ETH, and the others taking a third of this half – $2 trillion – each. Although BTC would become a smaller slice of the pie, the pie would be much bigger. From current market values, this means that BTC would double to $120,000. Chart I-6Cryptocurrency Corrections Are Becoming Less Extreme Cryptocurrency Corrections Are Becoming Less Extreme Cryptocurrency Corrections Are Becoming Less Extreme But the real action would be in the other cryptocurrencies. ETH would quadruple to $17,000, while some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. In conclusion, we expect the cryptocurrency asset-class to continue its strong structural uptrend, punctuated by short sharp corrections. As such, long-term investors should place up to 5 percent of their assets in cryptocurrencies. Coffee Is Too Expensive In this week’s fractal analysis, we make two observations: First, for those who want a second bite at the cherry for shorting the uranium meme theme, the spectacular rally in the Canadian stock Cameco offers a good opportunity – given its very fragile 260-day fractal structure, which has successfully signalled five previous turning-points (Chart I-7). Chart I-7Cameco Is Overbought Cameco Is Overbought Cameco Is Overbought Second, within the soft commodities, the spectacular rally in coffee combined with the recent sell-off in cocoa has stretched the relative pricing of the two softs to a 10-year extreme, as well as a very fragile 260-day fractal structure (Chart I-8). Chart I-8Coffee Is Too Expensive Coffee Is Too Expensive Coffee Is Too Expensive Accordingly, this week’s recommended trade is to short coffee versus cocoa, setting a profit-target and symmetrical stop-loss at 30 percent. 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 Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations