Policy

Highlights Increasing consumption should be a lot easier than increasing savings. After all, most people like to spend! It is getting them to work that should be challenging. Yet, the conventional wisdom is that deflation is a much tougher problem to overcome than inflation. It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town; fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring onerous financing costs. When the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. The pandemic banished the bond vigilantes. Governments ran massive budget deficits, but bond yields still dropped. While budget deficits will decline from their highs, fiscal policy will remain structurally more accommodative in the post-pandemic period. The combination of easier fiscal policy, increased household net worth, and other factors has raised the neutral rate of interest in the US and most other economies. This means that monetary policy is currently much more stimulative than widely believed. This is good news for equities and other risk assets in the near term, even if it does produce a major hangover down the road. New trade: Short US consumer discretionary stocks relative to other cyclicals. Consumer durable goods spending will slow as services spending and capex continue to recover. A Paradoxical Problem Economic pundits like to say that deflation is a tougher problem to overcome than inflation. We hear this statement so often that we do not think twice about it. In many respects, it is a rather strange perspective. Inflation results from too much spending relative to output, whereas deflation results from too little spending. Yet, people like to spend! One would think it would be much easier to get people to consume than to get them to work. The claim that deflation is a bigger problem than inflation is really just a statement about the limits of monetary policy. If the economy is overheating, central banks can theoretically raise rates as high as they want. In contrast, if the economy is in a deflationary funk, the zero-bound constraint limits how far interest rates can fall. Fortunately, there are other ways of stimulating the economy when interest rates cannot be cut any further. Most notably, governments can utilize fiscal policy by cutting taxes, spending more on goods and services, or increasing transfer payments. Getting Paid To Eat Lunch When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid for eating more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio. This sounds so counterintuitive that it is worth thinking through a simple example. Suppose you currently earn $100,000 per year and expect your income to rise by 8% per year. You have $100,000 in debt, which incurs an interest rate of 3%, and want to keep your debt-to-income ratio constant at 100% over time. Next year, your income will be $108,000, so you should target a debt level of $108,000. Thus, this year, you can spend $105,000 on goods and services, make $3,000 in interest payments, and take on $8,000 in additional debt. Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay an additional $6,000 in interest, your cash outflows will exceed your income by $16,000, taking your debt to $216,000 — exactly twice next year’s income. Notice that by maintaining a higher debt balance, you can actually spend $5,000 more while still keeping your debt-to-income ratio constant. Appendix A proves this point mathematically. One might protest that the interest rate you face would be higher if you had more debt. Fair enough, although in our example, the interest rate would need to rise above 5.5% for spending to decline. The more important point is that unlike people, governments which issue debt in their own currencies get to choose whatever interest rate they want. Granted, if central banks set interest rates too low, the economy will overheat, leading to higher inflation. But this just reinforces the point we made at the outset, which is that inflation and not deflation is the real constraint to macroeconomic policy. A Blissful Outcome For Stocks We would not have waded through this theoretical discussion if it did not serve a practical purpose. In April of last year, we wrote a controversial report asking if, paradoxically, the pandemic could turn out to be good for stocks. Chart 1 We noted that by combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards a “blissful outcome” where the economy was operating at full capacity, yet interest rates were lower than they were before (Chart 1). If such a blissful state were reached, earnings would return to their pre-pandemic level, but the discount rate would remain below its pre-pandemic level, thus allowing stock prices to rise above their pre-pandemic peak. In the months following our report, the stock market played out this narrative.   From Blissful To Blissless? Chart 2Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate More recently, bond yields have risen, stoking fears that we are moving towards less auspicious conditions for equities. There is no doubt that many central banks are looking to normalize monetary policy. That said, what central banks regard as normal today is very different from what they thought was normal in the past. Back in 2012, when the Fed began publishing its “dot plot,” the FOMC thought the neutral rate of interest was around 4.25%. Today, it thinks the neutral rate is only 2.5%. And based on the New York Fed’s survey of market participants and primary dealers, investors believe the neutral rate is even lower than the Fed’s estimate (Chart 2). Even if the Fed did not face political pressure to keep interest rates low, it probably would not want to raise them all that much anyway. The same applies to most other central banks. Why The Neutral Rate Is Higher Than The Fed Believes There are at least four reasons to think that the neutral rate of interest is higher than what the Fed believes:   Reason #1: The drag on growth from the household deleveraging cycle is ending As a share of disposable income, US household debt has declined by nearly 40 percentage points since 2008. Debt-servicing costs are now at record low levels (Chart 3). The Fed’s Senior Loan Officer Survey points to an increasing willingness to lend (Chart 4). The Conference Board’s Leading Credit Index also remains in easing territory (Chart 5). Chart 3The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course The Deleveraging Cycle Has Run Its Course Real personal consumption increased by only 1.6% in Q3. However, this was largely driven by a 54% drop in auto spending on the back of the semiconductor shortage. While vehicle purchases normally account for only 4% of consumer spending, the sector still managed to shave 2.4 percentage points off GDP growth in Q3. Chart 4Banks Are Easing Credit Standards Banks Are Easing Credit Standards Banks Are Easing Credit Standards Chart 5A Positive Signal For Credit Growth A Positive Signal For Credit Growth A Positive Signal For Credit Growth Spending on services rose by 7.9%, an impressive feat considering the quarter saw the peak in the Delta variant wave.   Reason #2: Fiscal policy is likely to remain accommodative in the post-pandemic period The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets (Chart 6). This point has not been lost on governments. While the flow of red ink will abate, the IMF estimates that the US cyclically-adjusted primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits (Chart 7). Chart 6 Chart 7 Chart 8A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Reason #3: Higher asset prices will bolster spending According to the Federal Reserve, US household net worth rose by over 113% of GDP between 2019Q4 and 2021Q2, the largest six-quarter increase on record (Chart 8). Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth, and 2-to-4 cents for every additional dollar of equity wealth. Based on the latest available data, we estimate that US homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption. And this does not even include any spending arising from the $2.4 trillion in incremental bank deposits that households have amassed since the start of the pandemic.    Chart 9Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Most Of The Deceleration In US Potential Real GDP Growth Has Already Occurred Reason #4: Population aging will drain savings Aging populations can affect the neutral rate either by dragging down investment demand or reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 9 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.8% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.5% over the next few decades. The average age of the US capital stock is now the highest on record (Chart 10). Whereas real business fixed investment is 6% below its pre-pandemic trend, core capital goods orders – a leading indicator for capex – are 17% above trend. Capex intentions remain near multi-year highs (Chart 11). All this suggests that investment spending is unlikely to fall much in the future. Chart 10The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record The Average Age Of The US Capital Stock Is Now The Highest On Record Chart 11Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Capex Intentions Remain At Lofty Levels Chart 12 In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 12). As baby boomers transition from net savers to net dissavers, national savings will fall. UnTaylored  Monetary Policy The Taylor Rule prescribes the Fed to hike rates by between 50-to-100 bps for each percentage point that output rises relative to its potential. Over the past decade, the Fed has favored the higher output gap coefficient, meaning that a permanent one percentage-point increase in aggregate demand should translate, all things equal, into a one percentage-point increase in the neutral rate of interest. Taken at face value, the combination of increased household wealth and looser fiscal policy may have raised the neutral rate in the US by more than five percentage points since the pandemic. This estimate, however, does not consider feedback loops: A higher term structure for interest rates would depress asset prices, thus obviating some of the wealth effect. Higher rates would also reduce the incentive for governments to run large budget deficits. Taking these feedback loops into account, a reasonable estimate is that the neutral rate in the US is about 2% in real terms, or slightly over 4% in nominal terms based on current long-term inflation expectations. This is close to the historic average for real rates, although well above current market pricing. The implication for investors is that US monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting. Higher Inflation Won’t Force The Fed’s Hand… Just Yet When will the Fed be forced to move away from its baby-step approach to monetary policy normalization and adopt a more aggressive stance? Our guess is not for another two years. Last week, we argued that inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps: Most of the recent increase in inflation has been driven by surging durable goods prices (Chart 13). Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation. Chart 13ADurable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Durable Goods Spending Has Further To Fall (I) Chart 13BDurable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) Durable Goods Spending Has Further To Fall (II) In modern service-based economies, structurally high inflation requires rapid wage growth. While US wage growth has picked up recently, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 14). The Fed welcomes this development, given its expanded mandate to pursue “inclusive growth.” At some point in the future, long-term inflation expectations could become unmoored. However, that has not happened yet, whether one looks at market-based or survey-based expectations (Chart 15). Thus, for now, investors should remain constructive on stocks. Chart 14Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Chart 15   New Trade: Short Consumer Discretionary Stocks Relative To Other Cyclicals We continue to favor cyclical stocks over defensives. Within the cyclical category, however, we are cautious on consumer discretionary names. Spending on consumer durable goods still has further to fall in order to return to trend. Durable goods prices will also come down, potentially squeezing profit margins. Go short the Consumer Discretionary Select Sector SPDR Fund (XLY) versus an S&P 500 sector-weighted basket of the Industrial Select Sector SPDR Fund (XLI), the Energy Select Sector SPDR Fund (XLE), and the Materials Select Sector SPDR Fund (XLB). Appendix A Image Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Image Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Image Current MacroQuant Model Scores Image

Highlights The 26th Conference of the Parties (COP26) will open this weekend in Glasgow, Scotland, amid a global crisis induced in no small measure by policies and regulations that led to energy-market failures. Price-distorting regulations and ad hoc fixes – e.g., retail price caps, "windfall profits" taxes – will compound the current crisis. Mad rushes to cover energy and space-heating demand in spot coal and gas markets when renewable-energy output falters will be repeated, given utility-scale battery storage will continue to be insufficient to replace hydrocarbons in the transition to a low-carbon economy.  On the back of higher coal, gas and oil demand, CO2 emissions will return to trend growth or higher this year (Chart of the Week). Base metals capex will have to increase at the mining and refining levels to meet renewables and EV demand.  This includes the need to diversify metals' production and refining concentration risks more broadly.1 We remain strategically long the COMT ETF and the S&P GSCI index, as these fundamental imbalances are addressed.  We also are initiating a resting buy order on the XME ETF if this basic materials ETF trades down to $40/share. Feature Going into the COP26 meetings starting this weekend, delegates no doubt will be preoccupied with the global energy crisis engulfing markets as the Northern Hemisphere winter approaches. In no small measure, the crisis is a product of poor policy design and regulatory measures meant to accelerate the transition to low-carbon economies globally. This is most apparent in China, the UK and the EU. China and the UK use retail price-caps to control the cost of energy to households. In China, the price caps recently brought state-owned electricity providers to the brink of bankruptcy, because suppliers were not able to pass through higher wholesale prices for coal and natural gas to retail consumers. In the UK, retail price caps actually did result in bankruptcies of smaller electricity providers. In the EU, price caps and "windfall profits" taxes are being imposed on retail energy providers in different states in the wake of the energy crisis.2 Chart 1 China's Impressive Renewables Push China has been making significant progress in introducing renewable energy to their energy supply mix, particularly wind and solar (Chart 2), accounting for 81.5% of Asia-Pacific's wind generation last year, and 55.5% of the region's solar generation. Chart 2 China generates just 11% of its energy from renewables. This has been insufficient to meet demand over the past year, owing to a combination of reduced coal supplies; colder-than-normal temperatures last winter, and hotter-than-normal temps during the summer brought on by a La Niña event. While energy demand was expanding over the course of the year due to strong economic growth in 1H21 and weather-related demand over the course of the year (for heating and cooling), provincial officials were vigorously enforcing the state-mandated "dual-control policy," which in some instances led to overly aggressive shutdowns of coal mines that left local markets short of the fuel needed to supply ~ 63% of the country's electricity.3 Chinese authorities have said that they would “go all out” to boost coal production in a bid to tackle widespread power cuts. Some 20 provinces in China have experienced electricity rationing and blackouts over the past month due to power-production shortfalls driven by a lack of coal. The power rationing was imposed due to a shortage of coal supply, which led to the surge in coal prices. The high coal prices, in turn, forced coal-power companies to cut back their production to avoid losses that threatened to bankrupt them.4 To be able to ensure coal and electricity supplies this winter, state authorities released new rules to enforce a policy scheme that includes increasing coal production capacity and revising the electricity pricing mechanism. China's state-owned Global Times news service reported more than 150 coal mines have been approved to re-open.5 The regional governments can prioritize their energy intensity targets over energy consumption. Coal-fired power prices, which are largely state-controlled, will be allowed to fluctuate by up to 20% from baseline levels. However, raising household tariffs is seen as a difficult task politically, given that China's per-capita income remains low.6 UK, EU Market-Distortions The UK electricity production and supply market consists of three segments – producing, distributing, and selling electricity. Entities can operate in any or all of these areas. As in many things, the UK punches way above its weight in renewables, accounting for 15% of wind generation and 7.5% of solar produced in Europe, as seen in Chart 2. Wind can supply ~ 25% of UK power, depending on weather conditions. For all renewables, the UK accounts for 14% of Europe's total generation capacity. Twice a year, the national energy regulator, The Office of Gas and Electricity Markets (Ofgem) sets a cap on the price at which electricity sellers or retailers can supply power to the final consumer. While the maximum price retailers can sell electricity to consumers is capped, the price they can buy it from the electricity producer is not. This price depends on market factors, including fuel costs. When wind power dropped sharply this past summer, electric suppliers were forced to scramble for natgas as a generation fuel, and, at the margin, coal. In the UK, natural gas powers more than 35% of the electricity mix, and accounts for 15% of Europe's natgas-fired generation. Coal generation in the UK accounts for 1% of Europe's coal fueled electricity generation. China's push to secure additional coal and natgas places it in direct competition for limited supplies with European buyers. High demand, stiff competition, reduced supply, and low inventories all contribute to higher gas prices globally (Chart 3). Easing pandemic related restrictions globally has released pent-up energy demand, which is expected to move higher over the next few months, as the Northern Hemisphere possibly sees another colder-than-normal winter, and economic growth boosts manufacturing demand. Chart 3 Capping selling prices during periods of very high fuel costs squeezes retailers’ profit margins. In the last six weeks, seven UK retailers have gone under, affecting ~ 1.5 million consumers. Such a system favors the incumbents: retailers that can produce their own electricity and hedge their exposure to price volatility have access to lower costs of capital and higher economies of scale. When retailers are no longer able to operate due to bankruptcy, their customers are distributed to the remaining suppliers. The British government would prefer to offer financial support to persuade larger companies to take on stranded consumers than save retailers who are being forced to go out of business.7 However, as wholesale gas prices rise, industry operators – even the more established ones – may not be keen to borrow from the government to take on additional consumers. The EU also finds itself facing stiff competition from Asia for natgas imports. According to Qatar’s energy minister, suppliers prefer Asian buyers since they purchase natgas on fixed long-term contracts to ensure energy security, unlike European buyers which purchase much of their  fuel on the spot market.8 The EU's natgas imports are projected to remain uncertain as Russian exports have fallen below pre-pandemic levels and supply via the NordStream2 pipeline is delayed. With one of the lowest working inventories within the EU (Chart 4), the UK, which imports ~ 65% of its natural gas, is unable to protect itself from supply volatility. These high prices coincided with low wind speeds earlier this year, curtailing wind power, which as of 2020, is the UK’s second highest electricity source. Chart 4 Unfocused Policy Hinders Energy Transition It is impossible to gainsay the merit of the decarbonization of the global economy. Disrupting weather patterns, spewing particulates and chemicals into the atmosphere, dumping plastics into the oceans and waterways, and ravaging forests worldwide do not contribute to any species fitness for survival. However, policymakers appear to be completely ignoring existing constraints any serious decarbonization effort would require. Encouraging the winddown of fossil fuels decades before sufficient renewable-energy and carbon-capture technologies are developed and deployed to replace the lost energy indirectly forces a harsh calculation: Do sovereign governments want to restrict income growth and quality-of-life improvements to the energy available from renewables (including EVs) at any point in time? Who actually makes that choice and enforces the rules and regulations that go with it? We have written about the enormous increase in base metals supply that will be required over the coming decades to develop and deploy renewables, most recently in La Niña And The Energy Transition last month. Base metals – like oil and gas markets – are extremely tight, and are operating in years-long physical deficit conditions, as can be seen in the bellwether copper and Brent markets (Charts 5 and 6). Chart 5Base Metals Markets Are Tight … Base Metals Markets Are Tight... Base Metals Markets Are Tight... Chart 6As Is Oil... As Is Oil... As Is Oil... Any policy contemplating a global buildout of renewable-energy generation and its supporting grids, along with EVs and their supporting infrastructure, should start with the recognition laws, regulations and rules need to encourage responsible, safe and sound incentives for developing the supply side of base metals markets. An argument also could be made for fossil-fuels, which arguably should receive technology subsidies and favorable tax treatment – not unlike those granted to renewables and EVs – to invest in carbon-capture tech development. Rules and regulations favoring long-term contracts so that producers are able to address stranded-asset concerns and secure funding for these projects also should be developed. Investment Implications Absent a more thought-out and focused effort to write laws, develop rules and regulations on at least the level of trading blocs, the evolution to a low-carbon energy future will be halting and volatile. This in an of itself is detrimental to funding such an enormous undertaking. Until something like it comes along, we remain long commodity-index exposure – the S&P GSCI index and the COMT ETF – and long the PICK ETF. At tonight's close we are opening a resting order to buy the XME ETF if if trades to or below $40/share.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish Crude oil markets unexpectedly moved lower mid-week on the back of yet another drop in Cushing, OK, inventory levels reported by the US EIA. Cushing crude-oil stocks stood at 27.3mm barrels vs. 31.2mm barrels for the week ended 22 October 2021. Two years ago, Cushing inventories were at 46mm barrels. Markets had been rallying on falling Cushing storage levels over the past couple of weeks. The EIA's estimate of refined-product demand – known as "Product Supplied" – remains below comparable 2019 levels at this time of year, although not by much (19.8mm b/d vs. 21.6mm b/d). We expect global oil and liquids demand to rebound above 100mm b/d in the current quarter. Stronger demand in 2022 and 2023 prompted us to raise our Brent forecasts to $80/bbl and $81/bbl, respectively (Chart 7). Base Metals: Bullish Copper continues to trade lower as markets price in a higher likelihood of softer demand for the bellwether metal as the global power-supply crunch weighs on manufacturing activity, particularly in China. Copper inventories are still at precariously low levels, with the red metal in global inventories hitting lows not seen since 2008 (Chart 8). This will keep copper's forward curve backwardated over time, as inventories are drawn to fill the gap between supply and demand globally. Low inventory levels are expected to persist as power rationing in China, which was responsible for more than 41% of global refined copper output in 2020, persists. Precious Metals: Bullish Federal Reserve Chairman Jerome Powell's remarks stating supply disruptions are expected to keep US inflation elevated next year are supportive to base metals. Higher inflation will increase demand for the yellow metal, as investors look for a hedge against USD debasement. However, the Fed's asset-purchase taper, which we expect to be announced in November, and the interest rate hikes we expect as a result of it beginning in end-2022, will push bond yields higher and raise the opportunity cost of holding non-yielding gold. That said, we believe the Fed will remain behind the inflation curve and will work to keep real rates weak, which will tend to support gold prices. Chart 7 Brent Forecast Lifted Slightly Brent Forecast Lifted Slightly Chart 8 Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y       Footnotes 1     Please see our report entitled La Niña And The Energy Transition, published on September 30, 2021, for discussion. 2     Please see Spain to Cap Windfall Energy Profits as Rally Hits Inflation published by bloomberglaw.com on September 14, 2021. 3    Please see carbonbrief.org's China Briefing for 23 and 30 September and 14 October 2021 for additional discussion, and fn 1 above. 4    Please see ‘All out’ to beat power shortages; 2050 ‘net-zero’ for airlines; ‘Critical decade” for global warming, published by China Brief on 7 October, 2021. 5    Please see Chinese officials move to increase coal output amid shortage published by globaltimes.cn 13 October 2021. 6    Data from the World Bank showed China's GDP per capita reached $10,500 in 2020, below the global average of $10,926. Some experts expect any reform to be gradual. 7     Please see Kwarteng insists UK will avoid power shortages as gas crisis worsens, published by the Financial Times on September 20, 2021. 8    Please see Qatar calls for embrace of gas producers for energy transition, published by the Financial Times on October 24, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned about the trebling of the crude oil price since March 2020? Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold The Korean Won Is Oversold The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Democrats are backing off from corporate tax hikes, a positive surprise for the earnings outlook. However, the reconciliation bill will be even more stimulating than expected at a time when the output gap is closed. Short-run inflation risks are high and Democratic bills will feed into that. Long-run inflation risks will need to be monitored. Compromises on legislation will help Democrats on the margin in the 2022 midterm elections but gridlock would freeze fiscal policy. Maintaining low corporate taxes while boosting government spending on infrastructure, R&D, renewables, and social safety should be good for productivity, potential growth, and the US dollar over the long run.   We still give 65% odds for the reconciliation bill to pass. Reconciliation is the critical means of avoiding a national debt default after the December 3 deadline. This assumes that bipartisan infrastructure passes (80% odds). With the market already pricing the impending Democratic agreement, we are closing our long renewable energy trade for a gain of 30% and our long infrastructure basket for a gain of 8%. Feature A major plot twist in Congress occurred over the past two weeks: corporate and individual tax cuts are on the chopping block as the December 3 deadline approaches for the Biden administration’s signature piece of legislation. This development is uncertain but not unlikely. It would fit with our annual theme of bipartisan structural reform in the sense that it would mark a further Democratic cooptation of the previous Republican administration’s policies for the sake of popular opinion. Investors should not bet on zero tax hikes but they should prepare for positive surprises relative to the 5.5%-7% corporate tax hike that was previously envisioned. Rotation from low-tax to high-tax sectors was already underway prior to this news, which favors that trend (Chart 1). Chart 1Democrats Scrap Corporate Tax Hike? Democrats Scrap Corporate Tax Hike? Democrats Scrap Corporate Tax Hike? In this report we update investors with the status of negotiations: what is in the bill, what is not, what remains undecided, what will be the net effect, and how will Wall Street respond? Details are subject to change up to the very moment before Congress votes. Here is what we know right now.   What’s Essential To The Bill? Before the reconciliation bill, the $550 billion bipartisan infrastructure bill still has a subjective 80% chance of passage. The Senate already approved it on August 10, with 19 Republicans in favor. It stalled in the House of Representatives because the left wing refused to vote for it until party leaders reached a framework agreement on the larger social spending bill. The latter can only pass via the partisan reconciliation process. That framework could be agreed any day now but even if it suffers a surprise delay the House can push through the infrastructure bill fairly quickly. Infrastructure stocks still have some room to rise in the lead-up to President Biden’s signature but their ability to outperform the market going forward will depend on a range of factors outside politics and policy (Chart 2). Chart 2Infrastructure Bill Already Priced Infrastructure Bill Already Priced Infrastructure Bill Already Priced As for the main reconciliation bill, House Speaker Nancy Pelosi claims that “more than 90 percent of everything is agreed to” in the framework agreement – but critical provisions are still in flux. The headline price tag has fallen from $3.5 trillion to $1.5-$2 trillion, leaving $1.75 trillion as the happy medium. The root of the disagreement is that the Democrats are a “big tent” party with two major factions of relatively equal strength. Moderates and conservatives have the upper hand on economics, whereas liberals have the upper hand on social issues (Chart 3). On the spending side, progressives have insisted on five policy priorities: the “care” economy (child care, elderly care), affordable housing, climate change, immigration, and health care. They say they can negotiate on the size and duration of the relevant programs but not on whether they are included.1 The Senate parliamentarian has already ruled out immigration so the other four priorities will be included, albeit watered down.  Chart 3 West Virginia Senator Joe Manchin’s initial demands to Senate Majority Leader Chuck Schumer are highlighted in Table 1. Manchin’s demands for a lower price tag are being met by the progressives’ willingness to pass smaller or short-lived programs with “sunset clauses.” The idea is that Republicans will suffer for allowing them to expire. History shows that it is very difficult to remove an entitlement once it is established. Table 1West Virginia Senator Joe Manchin’s Initial Demands For Biden’s Reconciliation Bill Chopping Block Chopping Block The following items look to be included but pared back in size: The Child Tax Credit (from $450 billion to ~$100 billion). This benefit was enhanced by COVID-19 stimulus and is likely to be kept in place, albeit for one year instead of five years. This sets up a “cliff” in December 2022.   Paid family and medical leave (from $225 billion to ~$100 billion). This benefit looks likely to be lowered from 12 weeks to four weeks and targeted toward low-income groups for a duration of three-to-four years. Medicare benefits expansion to include dental, vision, and hearing aid (from $358 billion to ~$200 billion or less). This provision is under pressure due to costs but Senator Bernie Sanders of Vermont insists that it will be included to some extent. Dental is likely to be slashed. This part of the bill was supposed to be paid for by allowing Medicare to negotiate drug prices, which is still being discussed. The Hill reports that the government may be given the power to negotiate prices for Medicare Part B but not Part D.2  On the revenue side, Pelosi says the deal will include a harmonization of overseas taxes. This would include a minimum 15% corporate tax rate on book earnings in keeping with the international agreement the Biden administration has negotiated. An estimated ~$400 billion in new revenue would be raised. Senators Manchin and Kyrsten Sinema of Arizona agree. Pelosi also claims agreement on tougher tax enforcement and a bulked-up Internal Revenue Service – a measure that is said to bring in $135 billion in revenue but which can be exaggerated to help cover the cost of new spending, at least on paper. What’s Already Been Chopped? Pelosi claims that the climate change disagreements are resolved. Manchin hails from a coal state where every single county favored President Trump for reelection. He  has nixed the Clean Energy Performance Program (CEPP) as well as any tax on carbon emissions.3 However, the $150 billion from CEPP will not be saved but redirected toward various other green energy projects. This solution confirms our view this year that Democrats would provide green subsidies but not punitive green measures. The US and global policy setting is favorable for renewable stocks, though the energy crunch in China and Europe is a sign that this trade is not a one-way trade since popular backlash against green policies is possible in future (Chart 4). Manchin is opposing the expansion of Medicaid to 12 states that have refused to expand it. The other 38 states had to pay 10% of the cost; a federal expansion would give it to the 12 laggards for free. Eliminating the provision entirely would put the onus back on the 12 states (useful for local Democrats) while cutting $141 billion from the overall cost of the reconciliation bill.4 Democrats have also agreed to cut the $88 billion proposal to make two years of community college tuition-free.   Chart 4Renewable Stocks Brush Off Energy Realism (For Now) Renewable Stocks Brush Off Energy Realism (For Now) Renewable Stocks Brush Off Energy Realism (For Now) Universal preschool (pre-kindergarten), which would cost $450 billion, is popular but now under fire. It is not in the list of progressive priorities and could be slashed. Housing aid at $300 billion is expected to be cut by half or more. Elderly care could fall from $400 billion to half or one-third of that. Immigration provisions are unlikely to appear in the final reconciliation bill, as noted above. The Senate Parliamentarian Elizabeth MacDonough has ruled that immigration is not germane to direct fiscal matters, which are the focus of the reconciliation process.5 The Democrats have a vested interest in immigration and are not acting with any urgency on the border in the meantime, setting up an immigration crisis in 2022 and beyond (Chart 5). Table 2 shows the original Democratic spending plan with annotations for the latest developments, which are all subject to change in the very near term. Chart 5Looming Crisis On Southern Border Looming Crisis On Southern Border Looming Crisis On Southern Border Table 2Senate Democratic Spending Plan Up For Negotiation Chopping Block Chopping Block What’s Next On The Chopping Block? On the revenue side, the following provisions are being debated: Corporate and Individual Tax Hikes: Senator Kyrsten Sinema of Arizona – who won her seat by a 2.4% margin in a state that President Biden carried by only 0.3% of the vote – has ostensibly succeeded in scrapping the corporate tax hike and individual income tax hike from the reconciliation package. Our guess is that these tax hikes will still somehow make it into the bill in a weaker form but if Sinema prevails then $710 billion in new revenue will be forgone.  Billionaire Tax: Democrats are also looking at a “billionaire tax,” although it would more accurately be called a hundred-millionaire tax based on what is known. It would be a yearly tax levied on the unrealized capital gains of those who own $1 billion in assets or who make $100 million in income over three consecutive years. Non-publicly traded assets would be taxed upon sale. This mark-to-market proposal is said to raise $250 billion in revenue, although nobody knows since tax evasion would be rife.6 It would be a popular tax but it is complex to administer, its constitutionality is uncertain, and it is being introduced in the eleventh hour. House negotiators would prefer straightforward corporate and high-income tax hikes.  Tax On Stock Buybacks: There is also a proposal to levy a 2% tax on stock buybacks, which would be popular and not so hard to implement as a wealth tax. But it is also being introduced late in the game. SALT Deduction Cap: Democrats from high tax states have relentlessly pushed to remove the cap on their deductions passed by Republicans. A temporary repeal for 2022-23 is being discussed but would be a handout to the upper and upper-middle class. Total repeal could deprive the overall package of $85 billion per year in revenue. Tobacco and E-Cigarettes: This tax is estimated to raise $97 billion but is regressive. Table 3 highlights the tax provisions according to the original Democratic plan along with annotations for recent developments. Table 3Democratic Tax Plan Up For Negotiation Chopping Block Chopping Block The Hyde amendment is lurking under the radar and could torpedo the entire bill – but we bet it will not. This provision has been included in legislation for half a century to prevent taxpayer money from directly funding abortion. President Biden, a Catholic, supported it until his 2020 presidential campaign when he caved to pressure from the progressives to remove it. However, Manchin insists on it.7 Since abortion is a moral dilemma, Manchin cannot compromise on it. Yet his “nay” would sink the entire reconciliation bill. So this is a mini-crisis waiting to happen and Hyde will most likely be included to save the bill. What’s The Time Frame? There are three soft deadlines and one hard deadline for these bills to pass. The soft deadlines are the following: October 31 – Transportation Funding Expires: House members want to pass the bipartisan infrastructure bill by October 31, along with a renewal of transport funds. This is a good plan because it separates bipartisan infrastructure from partisan reconciliation. But a short-term extension is also an option for transportation funding. It may be necessary if reconciliation is further delayed and House progressives refuse to support an infrastructure vote. November 1-2 – World Leaders Summit and UN Climate Change Conference: Democrats want a climate deal before Biden arrives in Glasgow, Scotland for the COP26 climate talks. It looks as if this will be achieved as we go to press. If not, Biden can offer vague promises instead. There will be no shortage of promises at Glasgow. November 9 – US Special Elections: If Democrats passed something before the various off-year elections are held then they would give their candidates a badly needed boost. Biden’s collapsing approval rating has been an albatross for Democratic candidates, including in the Virginia gubernatorial race (Chart 6). A signing ceremony at the White House would help take it off their necks. But lawmakers cannot speed up complex and controversial legislation just to save Terry McAuliffe’s bacon. The hard deadline is December 3, the new deadline for funding the federal government and raising the national debt limit. Chart 6 Republicans are unlikely to vote to raise the debt ceiling a second time this year so Democrats will most likely be forced to include it in the reconciliation bill. Importantly, the debt ceiling will help to ensure the reconciliation bill’s passage. Any Democratic senator or lawmaker who votes against the bill will bear unique responsibility for a default on the national debt and financial turmoil, not to mention the doom of his or her party in the midterm elections.  If anything this extreme cost suggests that our 65% subjectively probability for the bill’s passage is too low. What Are The Investment Implications? Democrats are likely to produce a $1.75-$2 trillion spending bill that raises around $1 trillion in new tax revenue. Our previous estimates of a net deficit impact of $1.2-$1.6 trillion for both the infrastructure and reconciliation bills will be updated when the framework reconciliation bill is put into writing but so far does not look far off the mark. Estimates for fiscal multipliers range widely (Table 4). The bipartisan infrastructure bill, with traditional or “hard” public investments, could have a multiplier of 0.4 to 2.2, based on the CBO’s retrospective 2015 estimates for the American Recovery and Reinvestment Act (the stimulus passed during the Great Recession). The partisan reconciliation bill, with “human infrastructure” and social welfare spending, could have a fiscal multiplier ranging from 0.6x (the average of the COVID-19 relief in 2020) to 1.2 or 1.4 (Moody’s estimates of the impact of expanding the Child Tax Credit in 2010).  Table 4Range Of Fiscal Multipliers For Government Spending Chopping Block Chopping Block However, the US output gap is virtually closed and stands at a positive 1.5% of GDP, according to Bloomberg consensus estimates (Chart 7). Thus additional deficit spending is inflationary on the margin. Core inflation is elevated and there is no immediate prospect for commodity prices to fall drastically in the next few months given tight global supplies, the approach of winter weather, and the looming conflict over Iran’s nuclear program in the Persian Gulf. A future political liability is thus taking shape. American consumers and small businesses are becoming increasingly concerned about inflation, much more so than taxes and regulation (Chart 8). By the time of the midterm election in fall 2022, inflation may have subsided. But if it has not then the Democrats will take the blame. Chart 7The Vanishing Output Gap The Vanishing Output Gap The Vanishing Output Gap Chart 8The Inflation Threat The Inflation Threat The Inflation Threat The equity sectors that stood to suffer the most from any repeal of President Trump’s Tax Cuts And Jobs Act of 2017 were real estate, technology, health care, and utilities. The sectors that stood to suffer least were energy, industrials, consumer staples, and materials. If Democrats maintain Trump’s corporate rate then the former sectors will see a relief rally. However, Big Tech will suffer marginally from the imposition of a minimum global corporate tax. The global macro context favors cyclical sectors and value stocks over defensive sectors and growth stocks as long as bond yields and inflation expectations continue to rise. Chart 9 shows that companies that were formerly high tax companies rallied tremendously in the wake of Trump’s tax cuts, while those with high foreign tax risk underperformed. That process will likely be reaffirmed if Trump’s headline corporate rate is preserved while the minimum rate is imposed on companies with high foreign tax risk. Over the long run, inflation may or may not prove to be as big of a problem. The Biden bills should boost productivity, on top of the productivity improvement that has already occurred as a result of COVID-19 digitization efforts. US corporates would maintain a high degree of competitiveness if the corporate rate were to stay put. The original Biden plan would have put the US back at the highest level of integrated corporate income taxes out of all the OECD countries. Keeping corporate rates low, combined with public investments in infrastructure, the digital economy, renewable energy, and the social safety net should boost productivity, potential growth, and the US dollar. Chart 9High-Tax Basket Stands To Benefit - Along With Value Stocks High-Tax Basket Stands To Benefit - Along With Value Stocks High-Tax Basket Stands To Benefit - Along With Value Stocks If Congress returns to gridlock after the 2022 midterm elections as expected, then the fiscal splurge may be on pause at least until 2025. In that case the inflation risk in coming years will depend more on global rather than domestic developments. We have long argued that inflation risks are rising due to populism and fiscal extravagance in the United States. The Biden administration’s legislation marks a return of Big Government and a net increase in the budget deficit over the coming decade. However, the latest developments suggest it will not be the extravagant democratic-socialist blowout originally envisioned. If that proves true, then its long-run impact will be beneficial for the US economy and politics.  On a deeper level, the most important takeaway from the above analysis is that the Democrats remain limited by checks and balances. Beneath all the partisan acrimony, a new consensus is emerging in the US in favor of proactive fiscal policy (infrastructure, social safety net) and more hawkish trade policy (supply chain resilience, onshoring). The drivers of this new consensus are powerful: the elites do not want rebellion, the masses want a more favorable domestic economy, and both want greater strategic security relative to foreign competitors. The likely passage of the Strategic Competition Act by the end of the year, or at least the semiconductor portion of it, and the passage of a bulked up annual defense bill despite Democrats’ allegedly dovish bias, will further emphasize this point.  By compromising the plan to come closer to moderate senators’ demands, the Democrats are courting the median US voter and likely to minimize their losses in the midterm elections. Even assuming they still lose the House of Representatives at least, the new policy consensus will continue to develop because it shares core elements with the Republican agenda.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Image Image Image Image Image Image Image Image   Footnotes 1     See Congressional Progressive Caucus, “CPC Calls For 5 Key Priorities To Be Included In The American Jobs Plan,” April 9, 2021, progressives.house.gov. See also Tyler Stone, “Rep. Ilhan Omar: If Our Progressive Priorities Aren’t Met, No Legislation Will Pass,” July 30, 2021, realclearpolitics.com. 2     See Jennifer Scholtes, Marianne Levine, and Alice Miranda, “What’s Still In The Dem Megabill? Cheat Sheet On 12 Big Topics,” Politico, October 25, 2021, politico.com; Jordain Carney, “Sanders draws red lines on Medicare expansion, drug pricing plan in spending bill,” The Hill, October 26, 2021, thehill.com.  3    Benjamin J. Hulac, “Manchin Tries To Slow Clean Energy Shift As West Virginia Clings To Coal,” Roll Call, October 26, 2021, rollcall.com. 4    Jordain Carney, “Manchin Says Framework ‘Should’ Be Possible This Week,” The Hill, October 25, 2021, thehill.com. 5    Lisa Desjardins, “Read the Senate rules decision that blocks Democrats from putting immigration reform in the budget,” PBS, September 20, 2021, pbs.org.  6    See Naomi Jagoda, “Billonaire Tax Gains Momentum,” The Hill, October 26, 2021, thehill.com; Steven M. Rosenthal, “Wyden’s Billionaire Income Tax Is Ambitious But Problematic,” Tax Policy Center, October 25, 2021, taxpolicycenter.org; Scott A. Hodge, “The Rich Are Not Monolithic and Taxing Their Wealth Invites Tax Collection Volatility,” Tax Foundation, October 26, 2021, taxfoundation.org. 7     Sam Dorman, “Biden says he’d sign reconciliation package including Hyde Amendment,” Fox News, October 6, 2021, foxnews.com.   

Highlights Bank of Canada: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Bank of England: Markets have aggressively shifted UK interest rate expectations, with a rate hike now expected before year-end. We expect that outcome to occur, but the vote will be close. Stay underweight UK Gilts in global bond portfolios. Maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Feature Chart of the WeekAn Inflation Shock For Bond Yields An Inflation Shock For Bond Yields An Inflation Shock For Bond Yields Steadily climbing inflation expectations, fueled by rising energy prices and persistent supply-chain disruptions, remain a thorn in the side of global bond markets. 10-year US TIPS breakevens have climbed to a 15-year high of 2.7%, while breakevens on 10-year German inflation-linked bonds are at a 9-year high of 2%. Rising inflation expectations are keeping upward pressure on nominal bond yields in the major developed economies, as markets start to slowly reprice the pace and timing of future interest rate increases (Chart of the Week). Market expectations on interest rates, however, can adjust much more quickly when policymakers change their tune. We have already seen that recently in smaller countries like Norway and New Zealand. Rate hikes delivered by the Norges Bank and Reserve Bank of New Zealand over the past month - which were telegraphed well in advance by the central banks – were a negative shock that pushed up bond yields in those countries. The next central bank “liftoff” within the developed economies is expected to occur in the UK and Canada, according to pricing in overnight index swap (OIS) curves (Table 1). In this report, we consider the outlook for monetary policy and government bond yields in both countries, which represent two of our highest conviction underweight recommendations. Table 1Markets Are Pulling Forward Rate Hikes UK & Canada: Next Up For A Rate Hike? UK & Canada: Next Up For A Rate Hike? Canada: Watch For A Bond Bearish Policy Shift In Canada, given the economic backdrop and policy constraints, we believe the Bank of Canada (BoC) will have to deliver on the hawkish market-implied path for interest rates, which calls for an initial rate hike to occur in Q2/2022 – much sooner than the central bank’s current messaging on liftoff. Chart 2ACanadian Inflation Not Looking So "Transitory" Anymore Canadian Inflation Not Looking So 'Transitory' Anymore Canadian Inflation Not Looking So 'Transitory' Anymore First on the BoC’s mind is inflation. Canadian CPI inflation came in at 4.4% year-over-year in September, blowing through analyst expectations and hitting an 18-year high (Charts 2A and 2B). The CPI-trim, a measure of core inflation which strips out extreme price movements, hit 3.4% year-over-year, the highest reading since 1991. All eight major components of the CPI rose on a yearly basis. On an annualized monthly basis, the energy-driven Transportation aggregate declined and less volatile components like Shelter (+1.1%) and Clothing (+0.7%) led the pack in terms of their contribution to the overall figure.   Chart 2 The data show that inflationary pressures are clearly broadening out in the Great White North, no longer constrained to “transitory” sectors. The effect of this inflationary pressure is also starting to make its mark on consumer and business sentiment. Chart 3Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment According to the BoC Survey of Consumer Expectations, the 1-year-ahead forecast of inflation reached a series high of 3.7% in Q3/2021 (Chart 3). While longer-term inflation expectations are more subdued, that doesn’t mean that inflation is not a worry for the Canadian consumer. With inflation expected to run much higher than expected wage growth (+2%) over the next year, consumers expect a decline in their real purchasing power. Correspondingly, consumer confidence is taking a hit—the Bloomberg/Nanos consumer sentiment index has fallen 7.3 points since the July peak. Canadian businesses are much more upbeat. The overall summary indicator from the BoC’s Business Outlook Survey for Q3/2021 climbed to the highest level in the 18-year history of the series (Chart 4). Firms reported continued expectations of strong demand, but with capacity constraints starting to weigh on sales - a quarter of firms surveyed reporting that a lack of capacity and skills will have a negative impact on sales over the next twelve months. In response, more companies are planning on increasing capital expenditure and hiring over the next year (Chart 4, middle panel). More than half of firms surveyed by the BoC indicated that investment spending will be higher over the next two years compared to typical pre-pandemic levels. Chart 4Canadian Businesses Are Brushing Up Against Capacity Constraints Canadian Businesses Are Brushing Up Against Capacity Constraints Canadian Businesses Are Brushing Up Against Capacity Constraints However, hiring plans will likely face difficulty, given the large share of firms (64%), reporting more intense labor shortages (Chart 4, bottom panel). A net 50% of respondents now expect wage growth to accelerate over the coming year, driven by a need to attract and retain workers amid strong labor demand. With regards to inflation, the BoC Business Outlook Survey measures the share of respondents that expect inflation over the next two years to fall within four different ranges—below 1%, between 1% and 2%, between 2% and 3%, and above 3% (Chart 5). We can “back out” a point estimate of expected inflation for Canadian firms by assigning a specific level to each of these ranges – 0.5, 1.5%, 2.5%, and 3.5%, respectively – and using the shares of respondents to calculate a weighted average expected inflation rate for the next two years.1 Based on this estimate, Canadian business inflation expectations have bounced rapidly since the 2020 trough and are now at all-time highs. The BoC has already begun to respond to the normalization of the economy and rising inflationary pressures indicated by its business survey by tapering the pace of its bond buying program. The Bank is now targeting weekly bond purchases of C$2bn, down from C$5bn at the start of the program and with another reduction expected at this week’s policy meeting (Chart 6). The size of the balance sheet has also fallen in absolute terms, driven by the Bank drawing down its holdings of treasury bills to virtually zero while also ending pandemic emergency liquidity programs. Chart 5Putting A Number To Canadian Business Inflation Expectations Putting a Number To Canadian Business Inflation Expectations Putting a Number To Canadian Business Inflation Expectations Chart 6The BoC Is Moving Towards Normalizing Policy The BoC Is Moving Towards Normalizing Policy The BoC Is Moving Towards Normalizing Policy The BoC now owns a massive 36.5% of Canadian government bonds outstanding – a share acquired in a very short time for this pandemic-era stimulus program. Thus, tapering now is not only necessary from a forward guidance perspective, signaling an eventual shift to less accommodative monetary policy and rate hikes, but also to ensure liquidity in the Canadian sovereign bond market. The remaining BoC tapering will be fairly quick, setting up the more important shift to the timing of the first rate increase. The Canadian OIS curve is currently pricing in BoC liftoff in April 2022, ahead of the BoC’s current guidance of a likely rate hike in the second half of the year (Chart 7). Given the developments on the inflation front, we are inclined to side with the market’s assessment of an earlier hike. Chart 7 In the longer run, rates might even be able to rise further than discounted in swap curves. The real policy rate, calculated as the policy rate minus the BoC’s CPI-trim measure, is negative and a significant distance from the New York Fed’s Q2/2020 estimate of the natural real rate of interest (R-star) for Canada of 1.4%. Admittedly, those estimates have not been updated by the New York Fed for over a year, given the uncertainties over trend growth and output gap measurement created by the pandemic shock. The BoC’s own estimates for the neutral nominal policy interest rate - last updated in April 2021 and therefore inclusive of any structural impacts of the pandemic on potential growth - range from 1.75% to 2.75%.2 The OIS forward curve expects the BoC to only lift rates to 2% in the next hiking cycle, barely in the lower end of the BoC’s neutral range of estimates. After subtracting the mid-point of the BoC’s 1-3% inflation target, presumably a level of inflation consistent with a neutral policy rate, the BoC’s implied real policy rate range is -0.25% to +0.75%. The current level of the real policy rate is near the bottom of that range. Thus, real rates, and the real bond yields that track them over time, have room to rise if the BoC begins to hike rates at a faster pace, and to a higher level, than the market expects. We see this as a likely outcome given the extent of the Canadian inflation overshoot and the robust optimism evident in Canadian business sentiment, thus justifying our current negative view on Canadian government bonds. To think about this mix of rising inflation expectations and increased BoC hawkishness down the road, and its implication for the Canadian inflation-linked bond market, we turn to our Canadian comprehensive breakeven indicator (Chart 8). This indicator combines three measures, on an equal-weighted and standardized basis, to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and the midpoint of the BoC’s 1-3% target inflation, and the gap between market-based and survey-based measures of inflation expectations. Going forward, we will be using the Canadian Business Outlook Survey measure of inflation expectations, introduced in Chart 5, for this indicator. Chart 8Upgrade Canadian Inflation-Linked Bonds To Neutral Upgrade Canadian Inflation-Linked Bonds To Neutral Upgrade Canadian Inflation-Linked Bonds To Neutral Two out of three measures point towards Canadian breakevens having further upside. Firstly, they are cheap under our fair value model, where the rise in breakevens has lagged the yearly growth in oil prices. Secondly, breakevens are a long distance away from the survey-based business inflation expectations. However, both forces are more than counteracted with Canadian headline inflation nearly two standard deviations from the BoC’s target, which indicates that the central bank must step in to address high realized inflation. Given these diverging signals on the upside potential for breakevens, we see a neutral allocation to Canadian linkers as more appropriate for the time being Bottom Line: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Will The BoE Actually Hike By December? Chart 9UK Gilts Have Been Hammered By BoE Hawkishness UK Gilts Have Been Hammered By BoE Hawkishness UK Gilts Have Been Hammered By BoE Hawkishness We downgraded our recommended stance on UK government bonds to underweight on August 11 and, since then, Gilts have severely underperformed their developed market peers (Chart 9).3 We had anticipated that the Bank of England (BoE) would be forced to shift their policy guidance in a less dovish direction because of rising UK inflation expectations. Yet we have been surprised by how quickly the BoE has shifted to an open discussion about the potential for imminent interest rate hikes. The BoE’s new chief economist, Huw Pill, commented in the Financial Times last week that UK inflation will likely hit, or even exceed, 5% by early next year, and that the November 4 Monetary Policy Committee (MPC) was “live” with regards to a potential rate hike.4 This followed BoE Governor Andrew Bailey’s comment that the Bank “will have to act” to contain rising inflation expectations. Mixed signals on economic momentum are not making the BoE’s decisions any easier. The preliminary October Markit PMIs ticked higher for both manufacturing and services, but remain below the peak seen last May. At the same time, UK consumer confidence has fallen since August, thanks in part to rapidly rising inflation that has reduced the perceived real buying power of UK consumers. High Inflation Might Last Longer Chart 10Why The BoE Is More Worried About Inflation Why The BoE Is More Worried About Inflation Why The BoE Is More Worried About Inflation The BoE’s last set of economic forecasts, published in August, called for headline inflation to temporarily climb to 4% by year-end, before gradually returning to the central bank’s 2% target level in 2022. Yet the BoE’s newfound nervousness over inflation is well-founded, for a number of reasons (Chart 10): The domestic economic recovery has led to a robust labor market, with job vacancies relative to unemployment fully recovering to pre-COVID levels. The 3-month moving average of wage growth remains elevated at 6.9%, although the BoE believes some of that increase could be due to compositional issues related to the pandemic. The BoE is projecting that the UK output gap is narrowing rapidly and would be fully closed in the second half of 2022. This suggests growing underlying inflation pressures were already in place before the latest boost to inflation from global supply-chain disruptions. UK energy costs are soaring, particularly for natural gas which remains the main source for UK electricity production. UK natural gas inventories are the lowest within Europe, yet the supply response from major providers has been slow to develop – most notably, Russia, which is seeking regulatory approval to begin shipping gas through the Nord Stream 2 pipeline. While natural gas prices have stopped rising, for now, inadequate supplies during an expected cold UK winter could keep the upward pressure on UK inflation from energy. UK house price inflation remains well supported, even with the recent expiration of the stamp duty reductions initiated as a form of pandemic economic stimulus. According to the Royal Institution of Chartered Surveyors (RICS), the ratio of UK home sales to inventories is still quite elevated (bottom panel). Given a still-favorable demand/supply balance, and low borrowing costs, UK house price inflation will likely not cool as much as the BoE would prefer to see. Stay Defensive On UK Rates Exposure The combination of rising UK inflation and increasingly hawkish BoE comments has resulted in a rapid upward repricing of UK interest rate expectations over the past few months (Chart 11). Markets now expect the BoE to raise Bank Rate to 1%, from the current 0.1%, by late 2022. More interesting is what is discounted after that. The OIS curve is pricing in no additional rate increases in 2023 and a rate cut in 2024. In other words, the market now believes that the BoE is about to embark on a policy mistake with rate hikes that will need to be quickly reversed. Chart 11Markets Are Pricing In A BoE Policy Error Markets Are Pricing In A BoE Policy Error Markets Are Pricing In A BoE Policy Error We think there is a risk of a more aggressive-than-expected BoE tightening cycle. The surge in UK inflation expectations is not trivial nor “transitory”. Looking at survey-based measures of expectations like the YouGov/Citigroup survey, or market-based measures like CPI swaps, inflation is expected to reach at least 4% both in the short-term and over the longer-run (Chart 12). If Bank Rate were to peak at a mere 1%, as indicated in the OIS curve, that would still leave UK real interest rates in deeply negative territory even if there was a pullback in inflation expectations. We expect the votes on whether to hike rates at either the November or December MPC meetings to be close. There will be a new Monetary Policy Report published for the November 4 meeting, which will include a new set of economic and inflation forecasts that will give the BoE a platform to signal, or deliver, a rate hike. In the end, we think that the senior leadership on the MPC has already revealed too much of its hawkish hand, and a rate hike will occur by year-end. Looking beyond liftoff into 2022, we still see markets pricing in too shallow a path for Bank Rate over the next couple of years, leaving us comfortable to maintain our underweight stance on UK Gilts. With regards to positioning along the Gilt yield curve, however, we see the potential for more curve steepening even if after the BoE begins to lift rates. The implied path for UK real interest rates, taken as the gap between the UK OIS forwards and CPI swap forwards, shows that markets expect the BoE to keep policy rates well below expected inflation for well into the next decade (Chart 13). At the same time, the wide current gap between the actual real policy rate (Bank Rate minus headline inflation) and the New York Fed’s most recent estimate of the UK neutral real rate (r-star) suggests that the Gilt curve is far too flat (bottom panel). Chart 12The BoE Cannot Ignore This The BoE Cannot Ignore This The BoE Cannot Ignore This Perversely, this creates a situation where the UK curve steepeners can be an attractive near-term hedge to an underweight stance on UK Gilts. Chart 13 If the BoE does not deliver on the strongly hinted rate hike in November or December, the Gilt curve can steepen as shorter-maturity Gilt yields fall but longer-dated yields remain boosted by high inflation expectations.However, if the BoE does hike and more tightening is signaled, longer-term yields will likely rise more than shorter-term yields as the market prices in a higher future trajectory for policy rates. Bottom Line: Stay underweight UK Gilts in global bond portfolios, but maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 For this calculation, we exclude firms that did not provide a response to the BoC Business Outlook Survey. 2 The Bank of Canada’s Staff Analytical Note on neutral rate estimation can be found here: https://www.bankofcanada.ca/2021/04/staff-analytical-note-2021-6/ 3 Please see BCA Research Global Fixed Income Strategy and European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. 4https://www.ft.com/content/bce7b1c5-0272-480f-8630-85c477e7d69 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

Highlights Treasuries: Bond investors should maintain below-benchmark portfolio duration and continue to short the 5-year note versus a duration-matched 2/10 barbell. For those investors who want to take an outright long position in US Treasuries, the 2-year Treasury note looks like the best security to choose. Municipal Bonds: This week we upgrade our recommended allocation to municipal bonds from overweight (4 out of 5) to maximum overweight (5 out of 5). Investors who can take advantage of the muni tax exemption should favor municipal bonds over Treasuries and over corporate bonds with the same credit rating and duration. In particular, we recommend that investors focus on long-maturity municipal bonds. Fed: Given our view that inflation will fall during the next 12 months, we still view December 2022 as the most likely liftoff date. However, we will continue to monitor our Five Factors For Fed Liftoff to see if our forecast needs to be revised. Feature Chart 1 Our call for a bear-flattening of the US Treasury curve has worked out well during the past few weeks. Long-maturity Treasury yields have almost risen back to their March highs, and the short-end of the curve has also participated in the recent bout of selling (Chart 1). In light of these moves, it makes sense to re-evaluate our nominal Treasury curve positioning. First, we consider whether, at current yield levels, it still makes sense to run below-benchmark portfolio duration. Second, we consider whether our current recommended yield curve trade (short the 5-year note versus a duration-matched 2/10 barbell) remains the best way to extract returns from changes in the yield curve’s shape. The next section of this report answers these questions by looking at forecasted returns for different Treasury maturities across a variety of plausible economic and monetary policy scenarios. Later in the report we look at municipal bond valuation and provide a quick update on last week’s Fedspeak. Forecasting Treasury Returns Chart 2 Three sources of Treasury bond return need to be considered when creating a forecast. Income Return: The return earned from the bond’s coupon payments. Rolldown Return: The return that a bond accrues simply by moving closer to its maturity date in an unchanged yield curve environment. Capital Gains/Losses: The return earned by a bond due to changes in the level and slope of the yield curve. We like to combine the income and rolldown return into one measure called “carry”. The carry can be thought of as the return an investor will earn in a specific bond if the yield curve remains unchanged throughout the investment horizon. Though carry is not the be all and end all of bond returns, it can be illuminating to look at the yield curve in terms of carry instead of the typical yield-to-maturity. Chart 2 shows the usual par coupon yield curve alongside the 12-month carry for each Treasury security. At present, the steepness of the 3-7 year part of the curve means that bonds of those maturities benefit a lot from rolldown. In fact, we see that a 7-year Treasury note will earn more than a 10-year Treasury note during the next 12 months if the curve remains unchanged. After calculating carry, the next step is to calculate capital gains/losses for each bond. To do this, we create some possible scenarios for future changes in the fed funds rate and assume that the yield curve moves to fully price-in that funds rate path over the course of a 12-month investment horizon.1  Next, we calculate the capital gains/losses for each bond based on the new shape of the yield curve in each scenario. Tables 1A-1D show the results from four different scenarios where the Fed starts to lift rates in December 2022. We then assume that the Fed will lift rates at a pace of 75-100 bps per year and that the funds rate will level-off at a terminal rate of either 2.08% or 2.58%. The 2.08% terminal rate corresponds to the median estimate of the long-run neutral fed funds rate from the New York Fed’s Survey of Market Participants. The 2.58% terminal rate corresponds to the median forecast from the Fed’s Summary of Economic Projections.2  Chart Chart Chart Chart The scenario shown in Table 1B is the closest to our base case. In this scenario, some short-maturity bonds deliver positive returns, but returns are negative for the 5-year maturity and beyond. Also, the 5-year note delivers the worst total return of all the maturities we examine. Unsurprisingly, expected returns for the longer maturities drop significantly if we raise our terminal rate assumption to 2.58% (Tables 1C & 1D). Therefore, any call to short the 5-year note versus the long-end relies on an assumption that the market will trade as though the terminal rate is closer to 2% than to 2.5% during the next 12 months. This is in line with our expectation. Finally, we observe that slowing our pace assumption from 100 bps per year to 75 bps raises expected returns across the board, but the 5-year still performs worse than the other maturities (Table 1A). Due to our expectation that inflation will fall during the next 12 months, a December 2022 liftoff remains our base case.3  However, the market has recently moved to price-in an earlier start to rate hikes. As of last Friday’s close, the fed funds futures curve was priced for liftoff in September 2022 and for a total of 49 bps of tightening by the end of 2022 (Chart 3). Chart 3Market Priced For September 2022 Liftoff Market Priced For September 2022 Liftoff Market Priced For September 2022 Liftoff Tables 2A-2D incorporate these recent market moves into our forecast by looking at the same scenarios as in Tables 1A-1D but assuming a September 2022 liftoff instead of December. The results are not all that different. Expected returns are worse across the board, but the 5-year still looks like the worst spot on the curve unless the market starts to price-in a higher terminal rate. Chart Chart Chart Chart Investment Conclusions Most of the scenarios we examined had negative expected returns for most maturities. We therefore still think it makes sense to keep portfolio duration low. Further, in every scenario the best expected returns can be found in the shorter maturities. In fact, the 2-year Treasury note offers positive returns in every scenario we examined. An outright long position in the 2-year Treasury note looks like a decent trade for investors forced to hold bonds. As for the yield curve, our results suggest that we should continue with our current positioning: short the 5-year note versus a duration-matched 2/10 barbell. The 5-year note performs worst in every scenario that assumes a 2.08% terminal rate. While it’s conceivable that investors will eventually push their terminal rate expectations higher, we think this is more likely to occur once the Fed has already lifted rates a few times. Bottom Line: Bond investors should maintain below-benchmark portfolio duration and continue to short the 5-year note versus a duration-matched 2/10 barbell. For those investors who want to take an outright long position in US Treasuries, the 2-year Treasury note looks like the best security to choose. The Duration Drift In Municipal Bond Valuations One under-discussed aspect of municipal bonds is that the securities tend to pay higher coupons than other bonds. That is, the bonds will often be issued with coupon rates well above prevailing yields. Investors therefore must pay a higher price to purchase the bonds, but they receive more return in the form of coupon payments. This feature of municipal bonds has important implications for how we should value them. For example, while the average maturity of the Municipal Bond index is much higher than the average maturity of the Treasury index, the muni index’s higher coupon rate makes its average duration significantly lower (Chart 4). This means that any valuation measure that compares a municipal bond’s yield with the yield of another bond with the same maturity will be unflattering for the muni. Chart 4Munis Pay High Coupons, Have Low Durations Munis Pay High Coupons, Have Low Durations Munis Pay High Coupons, Have Low Durations Further, since Treasury securities and corporate bonds tend to issue at par, the coupon rates paid by those securities have fallen alongside yields during the past few decades. Meanwhile, municipal bond coupons have been relatively stable (Chart 4, panel 3). This means that, over time, municipal bond durations have fallen significantly compared to the durations of other US bond sectors. A fair valuation measure would compare municipal bond yields with equivalent-duration Treasury yields and that is exactly what we’ve done. Chart 5A shows the spread between General Obligation (GO) muni bond yields and equivalent-duration Treasury yields. Chart 5B shows the spreads expressed as percentile ranks. For example, a percentile rank of 50% means that the spread is at its historical median, a percentile rank of 10% means the spread has only been tighter 10% of the time. Chart 5AGO Muni/Treasury Spreads I GO Muni/Treasury Spreads I GO Muni/Treasury Spreads I Chart 5BGO Muni/Treasury Spreads II GO Muni/Treasury Spreads II GO Muni/Treasury Spreads II The first thing that jumps out from our analysis is that municipal bonds are not that expensive. Shorter-maturity spreads were tighter than current levels as recently as 2019/20 and the long-maturity (17-year+) spread is positive, despite the muni tax exemption. In terms of percentile rank, spreads for all GO maturity buckets are only just below the historical median. However, spreads traded much tighter prior to the 2008 financial crisis and it may not be reasonable to expect munis to return to those tight mid-2000 valuations. Charts 6A and 6B repeat the exercise from Charts 5A and 5B but for Revenue bonds instead of GOs. The message is similar. Muni valuations are not that stretched compared to history, and investors can earn a before-tax spread pick-up in munis versus Treasuries if they focus on the long maturities. Chart 6ARevenue Muni/Treasury Spreads I Revenue Muni/Treasury Spreads I Revenue Muni/Treasury Spreads I Chart 6BRevenue Muni/Treasury Spreads II Revenue Muni/Treasury Spreads II Revenue Muni/Treasury Spreads II In fact, municipal bonds offer a before-tax yield advantage versus Treasuries for Revenue bonds beyond the 12-year maturity point and for GO bonds beyond the 17-year maturity point. Further, the breakeven tax rate for 12-17 year GOs versus Treasuries is a mere 1% and the breakeven tax rate for 8-12 year Revenue bonds is only 8%. Investors facing a tax rate above the breakeven rate will earn an after-tax yield pick-up in munis versus duration-matched Treasuries (Table 3). Table 3Muni/Treasury And Muni/Credit Yield Ratios The Best & Worst Spots On The Yield Curve The Best & Worst Spots On The Yield Curve Of course, municipal bonds also carry a small credit risk premium relative to duration-matched Treasuries. The GO and Revenue indexes have average credit ratings of Aa1/Aa2 and Aa3/A1, respectively, compared to a Aaa rating for US Treasuries. But we can control for credit risk as well by comparing municipal bonds to the US Credit Index and matching both the duration and credit rating. Even this comparison looks favorable for municipal bonds. Once again, long-maturity munis offer a before-tax yield advantage compared to credit rating and duration-matched US Credit. Meanwhile, breakeven tax rates for other maturities are low enough to attract most investors. Bottom Line: This week we upgrade our recommended allocation to municipal bonds from overweight (4 out of 5) to maximum overweight (5 out of 5). Investors who can take advantage of the muni tax exemption should favor municipal bonds over Treasuries and over corporate bonds with the same credit rating and duration. In particular, we recommend that investors focus on long-maturity municipal bonds, noting that the relatively low duration of these bonds makes them attractive relative to other bonds with similar risk profiles. Five Fed Factors A lot of Fedspeak hit the tape last week. Of particular interest were an interview with Chair Jay Powell on Friday and speeches by Fed Governors Randy Quarles and Chris Waller on Wednesday and Tuesday. One takeaway from their remarks is that a tapering announcement at the next FOMC meeting is very likely, with net asset purchases expected to hit zero by the middle of next year. The market, however, seems to have already taken the taper announcement on board. The more interesting aspects of the speeches were the discussions about how the Fed will decide when to lift rates and how elevated inflation readings may or may not influence that decision. We’ve noted in prior reports that five factors will determine when the Fed finally decides to lift rates, and last week’s comments gave us confidence that we’re on the right track. We run through our Five Factors For Fed Liftoff below, with some additional comments on why each factor is important (Table 4). Table 4Five Factors For Fed Liftoff The Best & Worst Spots On The Yield Curve The Best & Worst Spots On The Yield Curve 1. The Unemployment Rate The Fed has officially pledged through its forward guidance not to lift rates until “maximum employment” is reached. While the exact definition of “maximum employment” can be debated, there is widespread agreement that it includes an unemployment rate below its current adjusted level of 4.9%.4 More specifically, we inferred from the September Summary of Economic Projections that most FOMC participants view an unemployment rate of around 3.8% as consistent with “maximum employment” (Chart 7).5 Chart 7Defining "Maximum Employment" Defining "Maximum Employment" Defining "Maximum Employment" We expect that the Fed will refrain from lifting rates until the unemployment rate reaches 3.8%. 2. Labor Force Participation We explored the debate about labor force participation in a recent report.6 In short, there are some policymakers who believe that “maximum employment” cannot be achieved until the labor force participation rate has returned to pre-COVID levels. There are others, however, who think that an aging population and the recent uptick in retirements make such a return impossible. Randy Quarles, for example: I expect that as conditions normalize, [the labor force participation rate] will pick up, but it is unlikely to return to its February 2020 level. One reason is that a disproportionate number of older workers responded to the initial shock of the COVID event by retiring, which may be an area where participation and employment struggle to retrace lost ground.7 In his speech, Governor Waller also mentioned “2 million jobs” that will be lost forever due to retirements.8 While many policymakers cite increased retirements as a reason why the overall labor force participation rate will remain permanently lower, there is much broader agreement that a reasonable definition of “maximum employment” should include the prime-age (25-54) labor force participation rate being much closer to its February 2020 level (Chart 7, bottom panel). We think the Fed will refrain from lifting rates until the prime-age (25-54) labor force participation rate is close to its February 2020 level. 3.  Wage Growth Accelerating wages are a tried-and-true signal that the labor market is running hot. While wage growth is rising quickly right now (Chart 8), there is a strong sense that this is due to pandemic-related labor supply shortages and that wage growth will moderate as pandemic fears (and labor shortages) wane. Chart 8Wage Growth Wage Growth Wage Growth What will be more important is what wage growth looks like when the unemployment rate is close to the Fed’s target of 3.8%. At that point, accelerating wages will give the Fed a strong signal that a 3.8% unemployment rate really does constitute “maximum employment”. 4.  Non-Transitory Inflation Of our five factors, this is admittedly the most difficult to pin down. However, Governor Quarles did a good job of explaining non-transitory inflation in last week’s speech: The fundamental dilemma that we face at the Fed now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation. But the fundamental productive capacity of our economy as it existed just before COVID – and, thus, the ability to satisfy that demand without inflation – remains largely as it was, constraining demand now, to bring it into line with a transiently interrupted supply, would be premature. Essentially, Quarles is saying that the Fed does not want to respond to a pandemic-related supply shock by lifting rates and curtailing aggregate demand. The Fed only wants to tighten policy if it sees an increase in broad-based inflationary pressures that will not be contained naturally by a return to more normal aggregate supply conditions. Accelerating wages would be one signal of such broad-based inflationary pressures, as would be measures of core inflation excluding those sectors that have been most impacted by the pandemic supply disruptions (Chart 9). Lastly, we could also look at indicators of inflation’s breadth across its different components, which have recently spiked to concerning levels (Chart 10). Chart 9Non-Covid Inflation Non-Covid Inflation Non-Covid Inflation Chart 10CPI Breadth Has Spiked CPI Breadth Has Spiked CPI Breadth Has Spiked 5.  Inflation Expectations Inflation expectations are also critical to monitor. While all Fed participants seem to agree that inflation will fall during the next year, there is also widespread agreement that if high inflation causes inflation expectations to rise to uncomfortably high levels, then the Fed will be forced to act. Chris Waller: A critical aspect of our new framework is to allow inflation to run above our 2 percent target (so that it averages 2 percent), but we should do this only if inflation expectations are consistent with our 2 percent target. If inflation expectations become unanchored, the credibility of our inflation target is at risk, and we likely would need to take action to re-anchor expectations at our 2 percent target. At present, inflation expectations remain well-anchored near levels consistent with the Fed’s target (Chart 11). In particular, we like to track the 5-year/5-year forward TIPS breakeven inflation rate targeting a range of 2.3% to 2.5% as consistent with the Fed’s target. Incidentally, Governor Waller also flagged TIPS breakeven inflation rates as his “preferred” measure of inflation expectations in last week’s speech.  Chart 11Inflation Expectations Remain Well-Anchored Inflation Expectations Remain Well-Anchored Inflation Expectations Remain Well-Anchored The Fed will move much more quickly toward rate hikes if the 5-year/5-year forward TIPS breakeven inflation rate moves above 2.5%. Bottom Line: Given our view that inflation will fall during the next 12 months, we still view December 2022 as the most likely liftoff date. However, we will continue to monitor our Five Factors For Fed Liftoff to see if our forecast needs to be revised.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 All of our scenarios use a 12-month investment horizon and assume a term premium of 0 bps. 2 In both cases we assume that the fed funds rate trades 8 bps above its lower-bound, as is currently the case. 3 Please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. 4 We adjust the unemployment rate for distortions in the number of people employed but absent from work. Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 for further details. 5 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 6 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 7 https://www.federalreserve.gov/newsevents/speech/quarles20211020a.htm 8 https://www.federalreserve.gov/newsevents/speech/waller20211019a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Inflation in the US and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. Goods inflation will ease in 2022, while energy price pressures will abate. This suggests that we are currently near the top of those two steps. Any decline in inflation will be short-lived, however. Tight labor markets will bolster wages. Rent inflation is also poised to pick up, especially in the US. The Fed and other central banks will face political pressure to keep interest rates low in order to suppress debt-servicing costs. This could lead to overheating. While we are not as bullish on stocks as we were at the start of the year, the combination of low interest rates and above-trend growth over the next 12 months will support equities. Investors should favor cyclicals, value stocks, small caps, and non-US markets. The Stairway To Higher Inflation In past reports, we argued that global inflation had reached a secular bottom and would begin to reaccelerate (see here, here, and more recently here). While it is still too early to be certain, recent developments appear to have vindicated that view. The path to structurally higher inflation is likely to be a bumpy one. We have generally contended that the shift to a more inflationary regime would follow a “two steps up, one step down” pattern, characterized by a series of higher highs and higher lows for inflation. In thinking about the inflation process, it is useful to distinguish between transitory shocks and structural forces. Unfortunately, much of the recent discussion about inflation has been politically charged, with one camp arguing that high inflation is entirely transitory (mainly due to pandemic disruptions) and another camp arguing that it is entirely structural in nature (big budget deficits, QE, and “dollar debasement” are often cited). The idea that both transitory shocks and structural forces may be driving inflation seems to generate a lot of cognitive dissonance in peoples’ minds. Our view is that transitory shocks have pushed up inflation, but that structural forces (both policy and non-policy related) are playing an important role too. In other words, we think that we are near the top of those metaphorical two steps. The next step for inflation is likely down, even though the longer-term trend is to the upside. Team Transitory Is Right About One Thing During most recessions, cyclically-sensitive durable goods spending falls, while the service sector serves as a ballast for the economy. The pandemic flipped this pattern on its head (Chart 1). While durable goods spending did dip briefly, it came roaring back due to generous stimulus payments and stay-at-home restrictions which cut many households off from the services they normally purchase. In March of this year, US real consumer durable spending was 27% above its pre-pandemic trend (Chart 2A and 2B). Chart 1Unlike During Most Recessions, Durable Goods Spending Spiked Due To Stimulus Checks And Stay-At-Home Restrictions Unlike During Most Recessions, Durable Goods Spending Spiked Due To Stimulus Checks And Stay-At-Home Restrictions Unlike During Most Recessions, Durable Goods Spending Spiked Due To Stimulus Checks And Stay-At-Home Restrictions Chart 2ADurable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (I) Durable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (I) Durable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (I) Chart 2BDurable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (II) Durable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (II) Durable Goods Spending Has Begun To Normalize, But Durable Goods Prices Keep Rising Due To Supply Bottlenecks (II)     Durable goods spending has retreated since then, however. As of August, it was only 8% above its trendline. Supply-chain bottlenecks have curbed durable goods spending over the past eight months. A tell-tale sign of a supply shock is when spending declines and prices nonetheless rise. Between January 2020 and March 2021, durable goods spending increased at an annualized rate of 29% while prices rose at an annualized pace of 2%. Since March 2021, durable goods spending has fallen at an annualized pace of 28%, but price inflation has accelerated to 15% (Chart 3). Chart 3 Even more than other categories of durable goods, vehicle production has been stymied by supply-chain disruptions. Motor vehicles and auto parts represent about 40% of the durable goods sold in the US and accounted for nearly two-thirds of the decline in real durable goods spending between March and August. The downward trend in vehicle sales continued in September, with unit sales declining by 7.2% on the month. In the US, vehicle sales are now back to where they were in 2011 when the unemployment rate was 9%. In the euro area, they are below their sovereign debt crisis lows (Chart 4). The chip shortage hampering vehicle production will abate in 2022. However, vehicle prices are likely to come down only slowly. Auto inventories in the US are only a third of what they were prior to the pandemic (Chart 5). Until dealers are able to rebuild inventories, they will have little incentive to cut prices. Chart 4The Chip Shortage Has Caused Auto Sales To Tumble The Chip Shortage Has Caused Auto Sales To Tumble The Chip Shortage Has Caused Auto Sales To Tumble Chart 5Dealer Inventories Have Collapsed Dealer Inventories Have Collapsed Dealer Inventories Have Collapsed   Energy Price Pressures Should Abate, But Probably Not As Fast As Investors Expect Investors believe the recent surge in energy prices will reverse. The futures curves for oil, natural gas, and coal are all in steep backwardation (Chart 6). We agree that energy price pressures are likely to abate in 2022. However, as we discussed last week, the odds are that prices do not fall as quickly as anticipated. This concern is especially acute in Europe, where La Niña could lead to another cold winter and uncertainty abounds over the status of the Nord Stream 2 pipeline. Looking beyond the next 12 months, the risk is that years of declining investment in the oil and gas sector lead to continued energy shortages during the remainder of the decade. In 2020, 12% of global energy production came from renewable sources such as solar, wind, and hydro. The IEA estimates that this share will rise to 20% in 2030. However, the IEA also reckons that the global economy will still need about 5% more oil and natural gas than it consumes now (Table 1). Given the reluctance of many countries to invest in nuclear power generation, the phase-out of carbon-based fuels may take longer than expected. Chart 6 Table 1Oil And Gas Consumption Will Not Peak Until The Next Decade The Inflation Outlook: Two Steps Up, One Step Down The Inflation Outlook: Two Steps Up, One Step Down   Near-Term Upside For Rents Despite increasing home prices in most economies, rent inflation decelerated in the first year of the pandemic (Chart 7). More recently, however, the rental market has begun to heat up. US rents rose by 0.5% in September, the fastest monthly growth since the 2006 housing boom (Chart 8). The Zillow rent index, which looks only at units turning over, has spiked (Chart 9). Chart 7Rent Inflation Is Bouncing Back After Falling During The Pandemic Rent Inflation Is Bouncing Back After Falling During The Pandemic Rent Inflation Is Bouncing Back After Falling During The Pandemic Chart 8More Upside To Rent Inflation More Upside To Rent Inflation More Upside To Rent Inflation   Strong job growth, the end of the nationwide eviction moratorium, and the loosening of regulations freezing rents in a number of US cities and states are all contributing to higher rent inflation. A shortage of homes is also putting upward pressure on home prices and rents. After having surged during the Great Recession, the homeowner vacancy rate has fallen to record low levels (Chart 10). Chart 9Newly Listed Apartments Are Being Marked Up Sharply Newly Listed Apartments Are Being Marked Up Sharply Newly Listed Apartments Are Being Marked Up Sharply Chart 10The Home Vacancy Rate Is Very Low The Home Vacancy Rate Is Very Low The Home Vacancy Rate Is Very Low In addition to encouraging more construction, higher home prices could indirectly boost inflation through the wealth effect. According to the Federal Reserve, homeowner equity increased by $4.1 trillion, or 21%, between 2019Q4 and 2021Q2. Empirical estimates of the wealth effect suggest that consumption rises between 5 and 8 cents for every additional dollar in housing wealth. For the US, this would translate into 0.9%-to-1.4% of GDP in incremental annual consumption since the start of the pandemic. Higher Nominal Income Growth Would Make Housing More Affordable Chart 11Many Developed Economies Feature Overheated Housing Markets Many Developed Economies Feature Overheated Housing Markets Many Developed Economies Feature Overheated Housing Markets The housing wealth effect would turn negative if home prices were to fall. While this is less of a risk in the US where housing is still reasonably affordable in many states, it is more of a risk in countries such as Canada, Australia, New Zealand, and Sweden where home prices have reached stratospheric levels in relation to incomes and rents (Chart 11). Not only would a decline in nominal home prices curb construction and consumer spending, but it would also potentially undermine the financial system by reducing the value of the collateral backing mortgage loans. To support spending and preclude an outright fall in home prices, central banks would likely keep interest rates at fairly low levels. Low rates, in turn, would incentivize governments to maintain accommodative fiscal policies. The IMF expects the cyclically-adjusted primary budget deficit to be 2% of GDP larger in advanced economies in 2022-26 compared to 2014-19 (Chart 12). Chart 12 The combination of low interest rates and loose fiscal policies will help drive nominal income growth, thus allowing for improved home affordability without the need for a disruptive decline in home prices. As Japan’s experience demonstrates, a deflationary environment is toxic for the property market and the financial system. Labor Markets Getting Tighter There is little doubt that the US labor market is heating up. Even though there are 5 million fewer people employed now than at the start of the pandemic, the job vacancy rate is near record high levels and workers are displaying few misgivings about quitting their jobs (Chart 13). Part of the apparent tightness in the US labor market stems from pandemic-related factors. Although enhanced federal unemployment benefits have expired, households are still sitting on $2.4 trillion in excess savings (Chart 14). This cash cushion has allowed workers to be choosy in entertaining job offers. In addition, decreased immigration flows and a spate of early retirements have decreased labor supply. Chart 13 Chart 14 More recently, the introduction of vaccine mandates has caused some disruptions to the labor market. About 100 million US workers are currently subject to the mandates. According to the Census Household Pulse Survey, about 8 million of them are unvaccinated and attest that “they will definitely not get the vaccine.” Although many of them will reconsider, the anecdotal evidence suggests that some will not. In one glaring example, 4.6% of workers resigned from a rural hospital in upstate New York, causing the maternity ward to temporarily suspend operations. Prospects For A Wage-Price Spiral Chart 15Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly Wages At The Bottom End Of The Income Distribution Are Rising Briskly So far, much of the pick-up in wage growth has been confined to the bottom end of the income distribution (Chart 15). Wage pressures are likely to become more broad-based over time as the unemployment rate continues to decline. A full-blown wage-price spiral would worry the Fed. However, such a spiral does not appear imminent. While respondents to the University of Michigan survey in October expected inflation to reach 4.8% over the next 12 months, they anticipated inflation of only 2.8% over a 5-to-10-year horizon (Chart 16). This is not much higher than their pre-pandemic expectations and is lower than the 3.0% figure reported for September. Chart 16Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels Long-Term Inflation Expectations Have Risen But Remain At Historically Low Levels It is easy to dismiss households’ beliefs about future inflation as being largely irrelevant. However, these beliefs do influence spending decisions. For example, a record share of households say that this is a bad time to buy a car (Chart 17). The top reason given is that prices are too high. In other words, many households are deferring the purchase of a vehicle in the hopes of getting a better deal. Automobile demand would be a lot higher now if households thought that prices would keep rising, as this would incentivize them to buy a car before prices rose even more. Chart 17Households Think That This Is The Worst Time Ever To Buy A Car Households Think That This Is The Worst Time Ever To Buy A Car Households Think That This Is The Worst Time Ever To Buy A Car Chart 18Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s What should be acknowledged is that inflation expectations tend to be governed by complex social feedback loops, which makes the relationship between slack and inflation highly non-linear. The experience of the 1960s provides a pertinent example. The US unemployment rate reached NAIRU in 1962. However, it was not until 1966, when the unemployment rate was two percentage points below NAIRU, that inflation expectations became unhinged. Within the span of ten months, both wage growth and CPI inflation doubled, with the latter reaching 6% by the end of the decade (Chart 18). The lesson is clear: While long-term inflation expectations are well anchored today, there is no guarantee they will stay that way indefinitely. Is this a lesson that the Fed will heed? Like Larry Summers, we have our doubts, suggesting that the long-term risks to inflation are to the upside. Fighting The Last War Just as military generals are prone to fighting the last war, the same is true of economic policymakers. Central bankers have been staring down the barrel of the deflationary gun for over two decades. In the 1960s, policymakers prioritized high employment over low inflation. With memories of the Great Depression still fresh in their minds, they kept policy rates too low for too long. This time around, policymakers have an additional reason to drag their heels in raising rates: government debt is very high. Higher borrowing costs would force governments to shift spending from social programs to pay off bondholders. Needless to say, that would not be very popular with most voters. Reducing debt-to-GDP ratios via higher nominal income growth will prove to be more politically palatable than fiscal austerity. Investment Conclusions The path to high interest rates is lined with low interest rates. Structurally higher inflation will eventually lead to higher nominal interest rates, but not before an extended period of negative real rates. Chart 19Neither The Fed Nor The Markets Think The Neutral Rate Of Interest Is All That High Neither The Fed Nor The Markets Think The Neutral Rate Of Interest Is All That High Neither The Fed Nor The Markets Think The Neutral Rate Of Interest Is All That High Neither the Fed nor the markets think the neutral rate of interest is all that high (Chart 19). We think the neutral rate is higher than widely believed. However, this will not become apparent until the unemployment rate falls well below its full employment level. For now, the Fed’s leadership will want to avoid rocking the boat by turning more hawkish. While the US 10-year Treasury yield will trend higher over time, it will pause at around 1.8% in the first half of next year as the unwinding of pandemic-related bottlenecks leads to a “one step down” for inflation. The ECB and the Bank of Japan are even more reluctant to tighten monetary policy than the Fed. Some developed economy central banks like those of the UK, Norway, Sweden, Canada, and New Zealand are more inclined to normalize monetary conditions. That said, they too will be constrained by the fear that going it alone in raising rates will put undue upward pressure on their currencies. While we are not as bullish on stocks as we were at the start of the year, the combination of low interest rates and above-trend growth over the next 12 months will support equities. As we discussed in our recent strategy outlook, investors should favor cyclicals, value stocks, small caps, and non-US markets. Bitcoin Trade Update After being up as much as 50%, our short Bitcoin trade got stopped out for a loss. We remain bearish on Bitcoin and have decided to reinstate the trade.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights The ruling African National Congress will be difficult to displace in upcoming elections given the large economic role it plays in the public sector and in low-income households. Low growth outcomes will continue as the government navigates allocating state funds more efficiently, amid rising public debt, weak macroeconomic fundamentals and a fresh undertaking of fiscal austerity. The African National Congress is primed to claw back some lost voter support with President Ramaphosa at the helm. But Ramaphosa will also put a stop to fiscal austerity ahead of the 2024 general election. Our new South Africa Geopolitical Risk Indicator captures moments of significant political risk in the past and currently signals that the country is facing a geopolitical and political risk level last seen in 2016. The political status quo will remain for now, which is positive for investors. But China’s economic troubles and South Africa’s eventual need to inflate away its debt pose long-term risks for investors. Feature In the wake of COVID-19, South Africa has witnessed an increase of civil unrest. Severe looting in July 2021 only lasted a couple of days and was mostly contained to the central and eastern parts of the country but it nearly brought the country to a stand-still. The imprisonment of former President Jacob Zuma and a harsh lockdown amid resurging COVID-19 cases at the time fanned flames already lit by long-standing structural economic issues. The country has been stuck in a low growth trap for several years and government is facing constraints from rising debt levels. Yet the ruling party (the African National Congress, or ANC) will be difficult to displace in upcoming municipal elections and future general elections. It plays a large role in the public sector and low-income households depend heavily on government grants. Moreover, the ruling party also enjoys a “liberator” status, with voters pledging support to the ANC based on the party’s historical achievement of playing a major role in ending the apartheid regime. Unless the party implodes from within – possible but unlikely – the ANC will continue to rule, which is also the best outcome for investors at the current juncture. Low Growth Continues Amid High Debt The South African economy was straining before the pandemic and will continue to underperform going forward. Plagued by rampant corruption, misused state funds, and a lack of political leadership, the public sector has dragged on growth for several years now. Coupled with poor productivity in the primary and secondary sectors, South Africa’s economy faces headwinds which will affect future growth outcomes for years to come (Chart 1A). Chart 1   In the mining sector, the country’s top foreign exchange earner, output has been in a structural decline since 1980 even as the country has benefited from several commodity price booms (Chart 1B). More recently, Ramaphosa’s 2018 investment drive to rebuild South African industries has failed to galvanize a turnaround.1 Manufacturing is much of the same story as mining. Output has been in decline from 1990 and has reached its lowest level since mid-1960 (Chart 1C). The National Union of Metal Workers have recently undertaken a protracted strike that has lasted three weeks already – with many industry bodies citing the dangers of irreparable harm to production and severe job losses should the strike continue for much longer. Other factors such as intermittent electricity outages across the country will subtract from productivity going forward. Chart 1BPrimary Sector Productivity In Structural Downfall... Primary Sector Productivity In Structural Downfall... Primary Sector Productivity In Structural Downfall... Chart 1C...Followed By The Secondary Sector ...Followed By The Secondary Sector ...Followed By The Secondary Sector Chart 2Public Debt Is Ballooning Fast Public Debt Is Ballooning Fast Public Debt Is Ballooning Fast From longstanding misuse of public funds comes the ballooning public government debt (Chart 2). Our colleagues over at the BCA Emerging Markets Strategy team have assessed the state of fiscal policy and debt in South Africa and the outlook is bleak. The government is currently pursuing fiscal austerity measures to rein in debt. However, these measures are unlikely to be enough and will become politically untenable over time. Otherwise, to stabilize debt, policy makers will have to inflate their way out of debt servicing costs or increase fiscal spending to boost nominal GDP growth. According to the 2021 budget speech, real spending is projected to contract each year over the next three years. This marks the first cut to nominal noninterest government expenditure in at least 20 years. Other items such as health care will see spending cuts over the next three years and remain lower than 2013 levels. Social protection and job creation initiatives will also see spending cuts. Another large budgetary item that will see spending cuts is the public sector wage bill. The government has reiterated its commitment to curb this growing expense. Recent negotiations with civil servants saw only a 1.5% wage increase over the next year compared to an average growth rate of 7% over the last five years. Chart 3Government Spending Important To Demand Government Spending Important To Demand Government Spending Important To Demand Austerity measures will lower public sector demand and ultimately growth. However, if successful, they will bolster both potential economic growth and the ruling party’s support. The problem is the timing of the general election in 2024. The economic backdrop in the country remains weak. Assuming more civil unrest takes place, government finances will be burdened with picking up the cost again and appeasing the masses through higher social spending. Austerity measures will presumably be relaxed ahead of the 2024 vote. Government debt needs to be curtailed considering that debt servicing costs are the second largest expenditure item of the country’s national economic budget. But given how large the public sector contributes to local demand (Chart 3), the ANC will see pushback by trade unions and those that have been in its growing employ. However, pushback will not necessarily translate into an irreversible breakdown of political support. Trade unions have been part and parcel of the ANC since the party’s inception. The party will have to strike a balance to keep the unions on its side. Bottom Line: Under Ramaphosa’s leadership, government austerity measures will continue at least over the short to medium term but will most likely be balanced to ensure the ANC maintains control through the 2024 elections. Ramaphosa Strengthens The ANC Civil unrest is nothing new in South Africa. There have been various displays of civil unrest and riots in recent years. The most recent civil unrest led to over 300 civilian casualties, the deadliest since the apartheid era. However, casualties were mostly a result of public stampeding civilian-on-civilian violence. The government did not play a major role in these deaths compared to the Marikana massacre of 2012.2 Even then, despite the ANC facing backlash from the immediate community, the party suffered no major fallout nationally. Recent unrest was more widely spread this time around and serves as an early warning signal to the ANC that social risks are high and not abating. But as things stand, these events will not displace the ANC from power. Such events would need to occur more regularly across the entire country, for them to pose a real threat to ANC rule. Since taking the helm of the ruling party in late 2017, Ramaphosa is viewed a lot more favorably than his predecessor, Zuma, by most South Africans. Ramaphosa is more business friendly, transparent, and is at least trying to weed out corruption in government. The public view of Ramaphosa’s handing of COVID-19 has been improving. Even supporters of the Democratic Alliance, the official opposition, and the Economic Freedom Fighters, a radical far-left party, have shown a large improvement in their approval of Ramaphosa’s handling of the pandemic (Chart 4). The Economic Freedom Fighter’s growth has largely been driven by disgruntled ANC supporters in recent years. Seeing supporters of the Economic Freedom Fighters improve their approval of Ramaphosa is positive for the ANC in upcoming elections. Chart 4 The ANC has two significant backstops to any deep erosion of their voter base: feudalism and social grants. Feudalism is defined as a socioeconomic structure in which people work for a leader of a community or tribe who in return, give them protection and use of land. It still runs deep in South Africa and across its cultures and tribes. It gives life to the ANC, a strong base that the Economic Freedom Fighters will always have a tough time chipping away at. Rural voters matter most to the ANC and mostly live under feudal rule. Tribal leaders and village chiefs play a major part in everyday life for rural people. There is overwhelming support among these leaders for the ANC because the ruling party provides them with access to land, among other things. By contrast, the Democratic Alliance and the Economic Freedom Fighters have had little success in penetrating these barriers. Support for both of these parties is driven by urban dwellers. The overarching royal Zulu family is the biggest factor contributing to feudalism. The Zulu family will always support the ANC and ensure their people do too. The Zulus are the largest tribe of black South Africans and have significant interests in the ANC maintaining power, such as access to land and financial resources. Obviously they have historic ties to the founding of the ANC and past leaders of the ANC, including Zuma (but not Ramaphosa). Additionally, the tripartite alliance of trade unions, the South African Communist Party, and the ANC has always ensured that workers represented in labor unions across the country voted for the ANC. The candidate elected president of the ANC, and ultimately the country, has always had the backing of trade unions, represented by the largest, the Congress of South African Trade Unions.3 The Congress of South African Trade Unions has never waived their support of the ANC in any elections and have shown no interest in supporting any other parties. The social grants system is the second backstop. The ANC provides social payments to 22% of the population, of which approximately 76% of recipients vote for the ANC (Chart 5, top panel). That’s a significant amount of the population that will forego a large part of their economic livelihoods if they vote for the Economic Freedom Fighters or another party to rule the country. In the current climate of COVID-19, foregoing government grants in order to vote for another party will not happen. Voters are increasingly worried about losing their social grants if another party comes into power (Chart 5, bottom panel). While other parties like the Economic Freedom Fighters have promised to more than double the going social grant rate if they come to power, social grant recipients and ANC voters at large have not budged on this “promise.” A sure thing today is better than a gamble tomorrow. But, if the fiscal standing of the country teeters into a position whereby the ANC fails to meet its growing social grant liabilities, then the Economic Freedom Fighters will gain the most, even if its promises will be extremely difficult to back up. Upcoming municipal elections in November 2021 will put to the test whether the ANC will shed support like it did in the 2016 election (Chart 6, top panel). Under Zuma, the ANC’s losses were the Economic Freedom Fighter’s gains. In the 2019 general election this transfer of votes lost some momentum because of Ramaphosa’s ability to galvanize support for the ANC (Chart 6, bottom panel). The Economic Freedom Fighter’s rise has been driven by the party’s ability to berate the ANC on its systemic corruption, embodied in Zuma. With Zuma in jail and Ramaphosa cleaning up the party and government, the Economic Freedom Fighters will lose momentum in forthcoming elections.4 Chart 5 Chart 6 To the ANC’s benefit, opposition parties that won some significant metros in the 2016 municipal elections subsequently formed coalitions that have largely failed to govern well. Specifically, in the economic capital of Johannesburg, the ANC reclaimed a majority to govern the city through coalitions with smaller parties, after the Democratic Alliance and Economic Freedom Fighters governed the city following the 2016 election. While the ANC has only reclaimed one of three metros lost in the 2016 municipal elections, they have benefited from lackluster service delivery by opposition parties which has shown that there is no realistic alternative to the ANC right now.5 Bottom Line: As Ramaphosa cleans up the ANC and government, the ANC will shed less support to the EFF and look to claw back lost voters in forthcoming elections. Introducing Our South Africa GeoRisk Indicator Recent civil unrest in South Africa presents an ideal backdrop to introduce a new GeoRisk Indicator to our existing suite of thirteen indicators. Our newly devised South Africa GeoRisk Indicator captures moments of significant political risk in the past, including this year’s civil unrest, and currently signals that the country is facing a geopolitical and political risk level last seen in 2016, when President Zuma was on his way out of office (Chart 7). Chart 7South Africa Geopolitical Risk Indicator South Africa Geopolitical Risk Indicator South Africa Geopolitical Risk Indicator The South Africa indicator is based on the rand and US dollar exchange rate (ZAR/USD) and its deviation from four underlying macro variables that should otherwise explain its economic trend. These variables are: gold prices, emerging market equities, industrial production, and retail sales. The four variables cover South Africa’s commodity dependency, financial sector, and the supply and demand side of the domestic economy. All four variables exhibit sufficient correlation with the ZAR/USD for use in this indicator. If the ZAR/USD weakens relative to these variables, then a South Africa-specific risk premium is apparent. As with previous indicators, we ascribe that premium to politics and geopolitics, although this is a generalization, and a qualitative assessment must always be made. The indicator is effective in tracking the country’s recent history too. Events such as ex-President Zuma’s general election win in 2009, and his controversial firing of several finance ministers in late 2015, signal an increase in risk. Meanwhile, lower risk was implied when current president, Ramaphosa, was elected president of the ANC in late 2017, and later, in 2019, as president of the country. Some additional events worth highlighting include: (1) In late 2001 to mid-2002, the local currency lost significant value relative to the US dollar for several reasons. First, the 1998 Asia financial crisis continued to send aftershocks throughout the emerging markets. The ZAR was put through the ringer in forward markets by speculators on a frequent basis, buying cheaper in the spot and driving speculation in the forward market, making easy returns. This speculation was only compounded by the South African Reserve Bank’s intervention in the local currency market to curtail speculation through regulatory action. Second, money supply grew substantially from mid-2001 to early 2002, which is associated with exchange rate undershooting.6 Thirdly, adding to these factors, contagion risk from neighboring Zimbabwe, which was dealing with land seizures and food shortages at the time, played into risk aversion toward regional and South African assets. (2) Eskom, South Africa’s state-owned power utility company, implements more regular power outages amid struggles to supply rising demand. (3) Despite allegations of corruption, former President Zuma wins the ANC presidential nomination. Zuma becomes party president. (4) Former President Zuma wins the general election (5) Former President Zuma fires well-respected then finance minister Nhlanhla Nene (6) Former President Zuma fires well-respected then finance minister Pravin Gordhan (7) President Ramaphosa wins the ANC presidential nomination. Ramaphosa becomes party president. (8) Former President Zuma resigns from the presidency (9) Former US President Donald Trump tweets on white farm murders in South Africa7 (10) President Ramaphosa wins the general election (11) First COVID-19 case is reported (12) Civil unrest and looting In terms of South African assets, when geopolitical and political risk rises, investors favor alternative emerging market assets (Chart 8). In 2021, South African equities have climbed to levels last seen in 2018 on the back of an improving global growth outlook and swelling commodity prices. But recent civil unrest has seen local equities pull back a notch. If risks escalate further, local assets will continue to retreat. Chart 8Geopolitical Risk Signals Move To Alternative Bourses Geopolitical Risk Signals Move To Alternative Bourses Geopolitical Risk Signals Move To Alternative Bourses Investment Takeaways Table 1 provides a snapshot of equity performance, volatility, and relative valuations and momentum in South Africa compared to frontier markets, including African frontier markets, and emerging markets. Table 1South Africa And African Frontier Markets: Valuations, Momentum, Volatility South Africa: Ruling Party Will Stay South Africa: Ruling Party Will Stay Chart 9Wait And See On Frontier Markets Wait And See On Frontier Markets Wait And See On Frontier Markets Equity returns in South Africa have notched good gains as global growth picks up alongside rising commodity prices. On a risk-adjusted basis, however, Nigeria and Kenya are more attractive. The general aggregates of Frontier and African frontier markets are more attractive on the same basis. Price and timing wise, Table 1 shows valuations and momentum relative to other markets. South Africa is cheap but Nigeria is cheaper. On a cyclical basis, South Africa has more to offer than Nigeria. African countries such as Nigeria and Ghana are all prepped to move higher in the wake of cheaper currencies. But a widening financial crisis in China is a risk to these countries given how they have trended closely with Chinese total social financing (Chart 9). Meanwhile, Kenyan equities have outperformed. South African equities in US dollar terms have retreated somewhat following recent civil unrest and some contagion linked to China’s Evergrande crisis (Chart 9, second panel). If China secures its economic recovery, then higher commodity prices will boost miners and industrial stocks going forward. But this is not guaranteed. Upcoming municipal elections will aid investors in determining what to expect from the policy backdrop. We expect that the ANC will stabilize, i.e. not lose control of more cities, and this should throw some impetus back into local equities. Conclusion This year’s civil unrest was stark and disruptive but does not spell fundamental political destabilization or the end of ANC rule in upcoming elections. The South African economy is structurally weak and, aside from a bounceback on the post-pandemic recovery, will continue to lag its peers until the ANC and Ramaphosa get a solid grip on allocating state funds more efficiently, promoting a more friendly and stable business environment, and fighting corruption. Undertaking fiscal austerity now is not a bad thing for the ANC, but it will become an increasing political liability leading up to the next general election. Ramaphosa will have to pull the plug on fiscal cost cutting as soon as 2023, so as to allow demand to recover before voters head to the polls again in 2024. But this has longer term economic implications. Public debt will continue to rise in this case and add to debt default risk and debt servicing costs. If austerity is reinstated after elections, the South African economy will remain in a low growth trap. For now, tightening the fiscal belt is doable because of the dynamic created by the downfall of Zuma, giving support to austerity as a means of cutting back corruption, and the pandemic, which reinforces the ANC as the institutional ruling party during a time of national crisis.   Guy Russell Research Analyst GuyR@bcaresearch.com Appendix The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our South African GeoRisk Indicator (see Chart 8 above) makes use of the same methodology used for all thirteen of our other indicators. The methodology avoids the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the ZAR/USD, and compare its movement against several fundamental factors. These factors are the price of gold in US dollars, emerging market equities in US dollar terms, South African industrial production, and South African retail sales. Like our recently added Australia GeoRisk Indicator, South Africa is a commodity exporting country. South Africa is the largest producer of platinum in the world, and was the seventh largest gold producer by volume in 2019. Gold is South Africa’s largest export and the ZAR has a strong historic correlation to gold prices.8 Hence we use gold prices instead of platinum, which is less well correlated. South Africa also has a deep financial market, with lose capital controls and easy flow of funds. When sentiment toward EM equities is high, the ZAR benefits, and hence our inclusion of emerging market equities. On the supply and demand side of the economy, both industrial production and retail sales show a strong relationship with the ZAR. We include these as the last two variables measured in our indicator. All four variables exhibit strong correlation with the local currency. If the currency sharply underperforms them, then it must be weighed down by some risk premium, which we ascribe to domestic political and policy developments or the general geopolitical environment. Footnotes 1 In 2018, President Cyril Ramaphosa laid out a target of $100 billion in new investments over the next five years, primarily targeting primary and secondary industries. According to The United Nations Conference on Trade and Development, foreign direct investment flows into South Africa in 2020 almost halved to $2.5 billion from $4.6 billion in 2019, which was a 15% decline from around $5.4 billion in 2018. 2 The Marikana massacre was the killing of 34 miners by the South African Police Service. It took place on 16 August 2012 and was the most lethal use of force by South African security forces against civilians since 1976. 3 According to the International Labour Organization, South Africa’s union density rate was 28.1% in 2016. Strikingly, the public sector union density rate was approximately 70.1% compared to 29.1% in the private sector. 4 In June 2021, ex-President Jacob Zuma was sentenced to 15 months imprisonment for contempt of court, by failing to legally attend a tribunal on corruption in South Africa. Zuma has recently been released on medical parole. 5 In the 2016 municipal elections, the ANC lost control of three major metros. Pretoria (political capital), Johannesburg (economic capital) and (Port Elizabeth, or Nelson Mandela Bay). The official opposition (the Democratic Alliance) and the Economic Freedom Fighters formed governing coalitions in all three of the lost ANC metros. Opposition coalitions have struggled to govern more effectively than what the ANC did, given how far apart they are ideologically. In Pretoria and Nelson Mandela Bay, service delivery has been poor since, in line with ANC rule prior to 2016. In Johannesburg, the ANC won back the metro by forming a coalition with several smaller parties. Opposition coalitions are still in force in Pretoria and Nelson Mandela Bay. 6 Bhundia, A.J. and Ricci, L.A., 2005. The Rand Crises of 1998 and 2001: What have we learned. Post-apartheid South Africa: The first ten years, pp.156-173. 7 Donald Trump tweets "I have asked Secretary of State @SecPompeo to closely study the South Africa land and farm seizures and expropriations and the large scale killing of farmers." The South African government have not seized any farms nor have there been any recordings of large-scale farm killings. The tweet caused a minor sell-off in local assets at the time. 8 Arezki, Rabah & Dumitrescu, Elena-Ivona & Freytag, Andreas & Quintyn, Marc. (2012). Commodity Prices and Exchange Rate Volatility: Lessons from South Africa’s Capital Account Liberalization. Emerging Markets Review. 19. Jordaan, F. Y., & Van Rooyen, J. H. (2011). An empirical investigation into the correlation between rand currency indices and changing gold prices. Corporate Ownership & Control, 9(1-1), 172-183.