Policy

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Weakening Loan Demand Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Housing Activities Are Still Falling Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Large Current Account Surplus Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed A Setback For The Fed A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations 2022 Rate Expectations 2022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Short-term Inflation Expectations Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Long-term Inflation Expectations Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record The Fed’s Inflation Problem The Fed’s Inflation Problem Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Goods Inflation Goods Inflation Chart 8Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Peak Shipping Costs Peak Shipping Costs Chart 10The Upside In Real Yields The Upside In Real Yields The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Gross Leverage Is Falling Gross Leverage Is Falling Chart 12Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Leverage Ratios Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal.  The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong The Dollar Is Strong The Dollar Is Strong Chart 2More Hikes Prices In More Hikes Prices In More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Broadening US Inflation Broadening US Inflation Chart 4Getting To Maximum Employment? Getting To Maximum Employment? Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth A Pick Up In US Growth A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China The Dollar Loves A Weaker China The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 7 Chart 8Positive Momentum Signal For The Dollar Positive Momentum Signal For The Dollar Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem Europe Doesn't Have The US Inflation Problem Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave A New Wave A New Wave Chart 11Rate Differentials Hurt The Euro Rate Differentials Hurt The Euro Rate Differentials Hurt The Euro   Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Downside To Chinese Construction Activity Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Slowing Chinese Construction Is A Threat to EUR/USD Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? More European Equity Outflows? More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace The Nat-Gas Coup De Grace The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Negative Euro Sentiment Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Much Pessimism Is In The Price Much Pessimism Is In The Price Chart 18Peak US Inflation? Peak US Inflation? Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations What’s Going Wrong With The Euro? What’s Going Wrong With The Euro? Cyclical Recommendations What’s Going Wrong With The Euro? What’s Going Wrong With The Euro? Structural Recommendations What’s Going Wrong With The Euro? What’s Going Wrong With The Euro? Closed Trades Image   Currency Performance Fixed Income Performance Equity Performance

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) Chart 7 We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate House Price Appreciation Could Moderate House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD Chart 16 In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) Chart 7 We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate House Price Appreciation Could Moderate House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD Chart 16 In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Chart 4 Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. Chart 5 Chart 6 The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, 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. 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 13). Chart 13 Chart 14While 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   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). 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.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. Chart 16 The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost 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. It is telling that productivity growth has been extremely weak outside the US (Chart 17). 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 also noteworthy 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. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 17 Chart 18US Capex Should Pick Up US Capex Should Pick Up US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 21 Chart 22Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 24 Chart 25Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded.  Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1  If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics.  In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? King Dollar Breaking Out? King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective.  Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries.  Chart 2Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield.   Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome.  A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014.  French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified.  Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat.  Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States.   Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless.   Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive.   Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap Emerging Market Bull Trap Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1  “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Image Section II: Appendix: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (November 16 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET and November 17 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Revolving Credit On The Rise Again Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 8 Chart 9The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   Chart 10 The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 11 Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. Chart 14 In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas Chart 16 In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage 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 Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The 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 Chart 22Non-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 As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image