Sectors

Overweight BCA house view is for the US yields moving higher, with Treasury 10-year yields reaching 1.7-1.9% by the year-end.   Ever since the GFC, Financials and Banks equities relative performance has been tied to US yields, and these two sectors remain the most direct way to express a bearish bond bias within the US equity universe.  Consistent with that, our S&P Financials and S&P Banks overweight calls are currently up 4% and 8% in relative to SPX terms, respectively, since the position inception.  Two factors support further above benchmark allocation to the S&P Financials and the S&P Banks indexes. First, imminent tapering will propel yields higher.  Second, the broader economic revival and the accompanying easing in lending conditions will ensure a healthy demand pipeline for the US banks’ loans. Bank of America’s CEO, Brian Moynihan confirmed our view in his most recent earnings call citing that: “Deposit growth was strong and loan balances increased for the second consecutive quarter, leading to an improvement in net interest income even as interest rates remained low.” Bottom Line: We continue to recommend an above benchmark allocation in the S&P financials and the S&P banks indexes. An Update On Financials An Update On Financials

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 Faced with large excesses in the housing market, we contend that Beijing’s goal is to achieve flat property prices in the coming years. Stable property prices would allow for improved housing affordability over the coming years while precluding debt deflation. However, when authorities fix/control prices, they lose control of volumes/activity. The housing market will not clear. Property sales and construction activity will hit an air pocket. Shrinking construction activity will weigh on China’s economy and China-plays around the world. Feature The recent struggles of several Chinese property developers to service their debt have put the mainland’s real estate market on the radar of global investors. What is the outlook for the Chinese property market and what will be its impact on the mainland and global economies? What does it mean for global financial markets? In contrast to the US housing debacle in 2008, the central pressure point in China’s property market adjustment will not be home prices and mortgage defaults but retrenchment by property developers and a downsizing in construction activity. That is why we are maintaining our negative view on Chinese demand for raw materials and machinery. This will have implications for emerging Asia, developing countries that produce raw materials and machinery stocks worldwide. How Important Is The Property Market? Chart 1Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable In a 2020 paper,1 Kenneth Rogoff and Yuanchen Yang estimate that real estate investment accounted for 12-15% of GDP in China between 2011 and 2018. This compares with a 7% share of GDP in the US at the peak of the housing boom in 2005. Hence, the sheer size of real estate construction in China – which does not include infrastructure investment – implies that real estate investment is very important for the mainland economy. The above numbers do not capture secondary effects from fluctuations in real estate investment. Thereby, the impact of property construction is greater than what is implied by its share of GDP. Further, local governments derive more than 40% of their aggregate revenues – budgetary and off budgetary (managed funds) – from land sales (Chart 1, top panel). As land sales dry up, local government revenues will plummet, undermining their ability to finance infrastructure spending – which is also a major part of the economy. Property developers’ annual funding makes up a very large 20% of GDP, which attests to their importance to the economy and the financial system (Chart 1, bottom panel).  Critically, construction activity drives demand for raw materials and machinery. Granted, Chinese imports of raw materials and machinery used in real estate construction and infrastructure building are non-trivial, the shockwaves from the downturn will spill over to the rest of the world in general and to developing economies in particular. Excesses  The Chinese property market’s vulnerability stems from its excesses. These excesses are apparent on multiple fronts. Table 1Chinese Housing Is Expensive / Unaffordable China: Is The Property Carry Trade Over? China: Is The Property Carry Trade Over? 1. Extreme Overvaluation: Compared to most countries around the world, housing in China is very expensive. The house price-to-household income ratio is 19 in tier-1 cities, 10 in tier-2 and 7 in tier-3 cities (Table 1). For comparison, even after the recent surge in property prices, the house price-to-income ratio is 4 in the US nationwide. Importantly, the mortgage rate in China – currently at 5.4% – is considerably higher than mortgage rates in the US or in other developed economies. The high house price-to-income ratio and relatively high mortgage rate entail that mortgage interest payments account for a larger share of household income in China than in any advanced economy. For new buyers, assuming a 30% down-payment, mortgage interest payments alone make up 28% of household income on average nationwide (Table 1). Chart 2Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Finally, Chinese household indebtedness is much higher than is often presumed by the global investment community – the household disposable income-to-debt ratio is close to 100%, as high as it is in the US (Chart 2). All this does not mean that China will experience a US-style 2008 credit crisis with households defaulting on their mortgages. As we discuss below, the adjustment process will be different in China than it was in the US. 2. Capital misallocation: Property developers have been building the wrong type of housing at the wrong prices and for the wrong type of buyers. They have been building high-end houses and selling them at very high prices to high-income households who have been buying multiple properties as investments. This represents capital misallocation. Widespread home vacancies confirm this thesis. As of 2017, 21.5% of the housing stock was vacant according to the Survey and Research Center for China Household Finance.  As per the same source, only 11.5% of homebuyers in 2018 were first timers. That compares with 70% of first-time buyers in 2008-2010. In 2018, 22.5% of homebuyers already owned two or more dwellings while 66% owned one. Clearly, housing in China has become an object of speculation which has made it unattainable for first-time homebuyers. Chart 3Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets 3. Speculation and the carry trade: There is nothing wrong with individuals investing in real estate. This practice is widespread all around the world. However, contrary to many other countries, multiple home owners in China do not rent out their properties, but instead keep their houses vacant. For those few owners who rent their houses, the current rental yield on properties rarely exceeds 2%. Given that the mortgage rate is currently 5.4%, the carry costs for individual investors is negative. Therefore, property investors in China can only expect to profit from ever rising prices. This strategy has paid off enormously over the last 20 years. Yet, past performance does not guarantee future gains. A stampede into real estate since 2009 has made housing extremely expensive and has instigated socio-political problems that have made Beijing wary. Critically, property speculation has been prevalent not only among households but also among property developers. The latter have been participating in the largest carry trade of the past 12 years. Facing borrowing costs that were lower than the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the form of land, incomplete construction as well as completed but unsold properties. Chart 4Property Developers Are Very Leveraged Property Developers Are Very Leveraged Property Developers Are Very Leveraged As long as the rate of annual asset price appreciation exceeds the borrowing costs (the carry), carrying these assets on a balance sheet produces lofty profits. The top panel of Chart 3 demonstrates that housing starts have chronically exceeded completions, i.e., developers have been starting but not completing/delivering properties. The gap between starts and completions – unfinished construction – has ballooned (Chart 3, bottom panel). In short, property developers have been holding on to a lot of land and unfinished construction and have been financing it via debt. The asset-to-equity ratio for property developers trading on the A-share market has surged to 9 (Chart 4).  Overall, the primary reason for real estate asset accumulation in China by individuals and companies has been expectations of continuous price appreciation. When an investor purchases an asset that generates little or no recurrent cash flow and the only rationale for holding onto it is expectations for continuous price appreciation, it qualifies as speculation – not investment. This speculation can continue only as long as there is demand from new buyers. Bottom Line: The property market is suffering from numerous excesses such as extreme overvaluation, capital misallocation and widespread speculative activities. Clouds Are Forming Over Real Estate Odds are that the speculative fever that has held the Chinese housing market in its grip is waning. Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand First, the three red lines introduced by authorities a year ago limit property developers’ ability to take on more debt. In fact, many property developers are being forced to reduce their indebtedness to meet these regulatory requirements. These rules mean that property developers will have to reduce new construction at best or sell their assets at worst. When many developers try to offload their assets simultaneously, asset prices will deflate, producing a vicious debt deflation cycle. Second, the reluctance of authorities to bail out large property developers – which are struggling to service their debt – is sending a clear message to both onshore and offshore creditors not to lend to property developers. This is especially true for small and medium banks, trust companies, wealth management products and onshore and offshore bondholders. These lenders along with pre-sales account for the lion’s share of financing options for property developers. Chart 5 illustrates that diminishing funding for property developers weighs down on completion, i.e., less construction work and less demand for raw materials and machinery (Chart 5, bottom panel). Third, the property carry trade does not make sense when the rate of real estate asset price appreciation drops below property developers’ borrowing costs. A negative carry means incurring losses, necessitating the sale of assets, including land and completed properties. A rush to offload assets amid a buyer strike could prompt classic debt deflation. Chart 6Households’ House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Finally, the upcoming pilot program for a real estate tax and a broader public campaign by Beijing against buying houses as an investment has discouraged individuals from purchasing properties. The proportion of households planning to buy a house has dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 6). House sales contracted by 16% in September from a year ago and initial reports point to further deterioration in October.     Bottom Line: Central authorities in China are attempting to tackle the property market because they reckon that an expensive and speculative property market could either create socio-political problems down the road or get out of control and crumble of its own accord. Beijing’s objective is to achieve a soft landing by acting preemptively and managing it.  The Role Of Policy Why is Beijing obsessed with taming the property market? We suspect the current hawkish stance is due to the following: Chart 7Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing is becoming unaffordable for low- and some middle-income residents in China. This may give rise to a sense of injustice/inequality and goes against president Xi’s common prosperity goals. This is also negatively affecting family formation and demographics and, ultimately, the nation’s potential growth rate. Beijing believes that the 2019 protests in Hong Kong were to a certain extent due to housing unaffordability. The latter fanned young people’s rage toward authorities and the political system. The Communist party leadership wants to avoid a similar uprising in the mainland. Anytime policymakers have stimulated in the past 12 years, property prices have surged widening the gap between the poor and the rich and making housing even more unaffordable. Presently, they are reluctant to do the same. Also, authorities are clamping down on property developers because historically there was a strong positive correlation between property starts and house prices (Chart 7). The basis for this positive correlation is that whenever property developers start new projects, they raise expectations of higher future prices via aggressive marketing. As a result, people become more inclined to buy houses. In fact, over the years more supply has not precluded property prices from surging and vice versa, as shown in Chart 7. Finally, the central government has learned from its own experience in 2015 and from the US case in 2008 that when a bubble bursts, it is difficult to stop it. Chinese economic policymakers prefer to be proactive than reactive. All of the above does not mean that authorities are planning to instigate a property market crash and will stand by and not stimulate. If and when broad economic conditions deteriorate to the point that income growth and employment are jeopardized, authorities will rachet up their stimulus. Presently, the unemployment rate for the 25-59 age group is very low and the urban labor market is tight (Chart 8). In addition, the nation’s exports are booming, so it is a good time to undertake some deleveraging. In brief, there is now no urgency to stimulate aggressively. Bottom Line: Considering the size of the real estate market and how dire its fundamentals are, we expect economic conditions to get much worse in China. That will ultimately force policymakers to stimulate more aggressively. The End Of The Property Carry Trade Conditions have fallen into place for the property carry trade by developers to unravel: Faced with limited access to funding, a diminished willingness on the part of creditors to rollover their debt as well as plummeting home sales, property developers have already dramatically cut back on land purchases (Chart 9, top panel). Chart 8China's Labor Market Is Strong China's Labor Market Is Strong China's Labor Market Is Strong Chart 9China's Construction Cycle In Perspective China's Construction Cycle In Perspective China's Construction Cycle In Perspective   However, they have so far been completing and delivering pre-sold homes to buyers who had paid in advance. In the last couple of years 90% of homes have been pre-sold. Hence, these completions do not generate new cash inflows for real estate developers. Yet, this completion work has supported construction activity and demand for materials over the past 12 months (Chart 9, bottom panel). Looking forward, reduced funding entails shrinking completions with negative ramifications for the economy (Chart 5 above). Real estate deflation, lack of new sales and restricted financing could turn property developers’ liquidity troubles into a solvency issue. This is how typical financial/credit crises develop – they start with liquidity strains and then turn into solvency problems as the value of collaterals drop, becoming insufficient to cover debt obligation. Defaults ensue. Property development is an extremely fragmented industry in China. There are officially around 100 000 property developers in China. Even the largest ones like Evergrande have a very small share of the market. Therefore, authorities cannot ensure that the sector will function properly by ring fencing or bailing out several large developers. In sum, authorities have very little control over real estate construction because it is quite spread out across the country and involves many private small- and medium-sized developers. We think that Beijing’s goal is to achieve flat property prices in the coming years. Authorities realize that property deflation could be devastating but are also less tolerant of growing excesses and imbalances in this area. Flat home prices and rising incomes will lead to a lower house price-to-income ratio, i.e., will make home ownership more affordable. In short, policymakers are attempting to fix property prices to achive a soft landing. Yet, there is a caveat: when authorities fix/control prices, they lose control of volumes/activity. This will likely be the case in China. Without meaningful drop in house prices, low-and middle-income first-time homebuyers will not become buyers right away and healthy property developers will be unwilling to snap up the assets of their troubled competitors. Hence, the market will not clear and the property sales and construction activity will hit an air pocket. Bottom Line: After more than a decade of speculative excesses, policymakers have embarked on the very difficult task of controlling house prices. They can control house prices via administrative measures. Yet, as expectations of rapidly rising property prices vanish, land sales, home purchases and property construction will likely shrink substantially for a period of time. Investment Recommendations A few market-relevant observations: Chinese non-TMT stocks and China-related plays globally are at risk from shrinking construction activity on the mainland. Critically, EM non-TMT stocks have not priced in the slowdown. Chart 10 illustrates that China’s credit and fiscal spending impulse is back to its previous low, but EM non-TMT stocks have not corrected much. In the past, Chinese onshore property stocks correlated with global material stocks (Chart 11). The basis is that China’s construction accounts for a considerable share of global raw materials consumption. Hence, the bear market in Chinese property stocks is raising a red flag for global material stocks. Chart 10EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown Chart 11A Red Flag For Global Materials A Red Flag For Global Materials A Red Flag For Global Materials   EMs are most vulnerable, and the US is the least exposed to China’s construction and infrastructure investment segments. The basis is that the US is a closed economy and trades very little with China. That is why we believe that the US dollar has more upside and US equities will continue outperforming the global stock index as China’s slowdown persists. Putting it all together, we recommend the following strategies: Avoid EM stocks and underweight EM versus DM in a global equity portfolio. Continue shorting select EM currencies versus the US dollar. Avoid local currency bonds and favor US credit over EM credit markets. Avoid bottom fishing in Chinese offshore corporate bonds, including high-yield ones. As for Chinese equities, investors should stay with the long onshore A shares / short investable index strategy. We also reiterate a strategy we have been recommending for both onshore and offshore stocks since May 9, 2019: short property stocks relative to the benchmark. This has been a very profitable trade. Today, we recommend closing the long position in Chinese insurance stocks given that credit woes will worsen before they improve. One way for global investors to bet on China’s slowdown while hedging the risk of stronger growth in DM is via the following trade: short global materials / long global industrials. Our report from July 30 elaborated the bullish case for global industrials beyond China’s slowdown. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1 See Kenneth S. Rogoff and Yuanchen Yang, "Peak China Housing," National Bureau of Economic Research, August 2020. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

With 119 S&P 500 companies having reported Q3-2021 earnings, it’s time to take a pulse of the interim results. So far, the blended earnings growth rate is 34.8% while actual reported growth rate is 49.9%. The blended sales growth rate is 14.4%, while the actual reported rate is 16.6%. Analysts expected Q3-2021 earnings to be 6% below the Q2-2021 level. As of now, this quarter’s earnings are only 3% lower. Most of the companies that have reported are beating analysts’ forecasts are surprising to the upside. Currently, 83% of companies reported EPS above expectations, with five out of eleven sectors delivering an impressive 100% beat score. In terms of the magnitude of the beats, the overall number currently stands at 14% with Financials and Technology leading the pack. However, these results are bound to change as more companies report: less than 5% of the market cap has reported within the Energy, Materials, Real Estate, and Utilities sectors. The big theme for the current earnings season is input cost inflation. Many industrial giants, including Honeywell (HON), are complaining about supply-chain cost increases, and their potential adverse effect on margins. As a result, many companies are reducing guidance for the fourth quarter. So far, there are 59 positive pre-announcements, and 45 negative. On the bright side, the majority of companies are reporting that demand for their products remains strong, potentially offsetting some of the cost increases. This is especially the case with consumer demand: a few consumer staples companies, such as P&G, commented that their recent price hikes have not dampened demand for their products and have fortified their bottom line against rising costs. Bottom Line: The earnings season is gaining speed, and so far, it appears that Q3-2021 growth expectations are set at a low bar, that is easy to clear for most companies. Chart

Highlights Contrary to popular belief, the correlation between changes in interest rates and equity returns is not fixed: Stock prices have generally risen as yields have fallen over the last four decades, but there is no rule that states equity returns and bond yields will be inversely related. Tech stocks’ tight recent inverse correlation with interest rates is a new phenomenon and we expect it will be temporary: Relative differences in earnings have driven relative returns since the global financial crisis and their mirror image correlation with interest rates was a pandemic anomaly that has already withered. Rising interest rates are not a good reason for equity investors to reduce their Tech exposures: The conventional wisdom is not always wrong, but it almost never generates alpha. In this case, we believe the crowd has fallen for a fleeting illusion that will not persist. Feature Table 1Lapping The Field Tech Stocks And Interest Rates: Less Than Meets The Eye Tech Stocks And Interest Rates: Less Than Meets The Eye Perhaps nothing has lately generated more consensus agreement among equity strategists and other top-down observers than the claim that Tech stocks are particularly vulnerable to rising interest rates. Thanks to the Tech sector’s track record of generating outsized growth (Table 1), its future earnings streams are expected to be larger for longer than other sectors’, making them somewhat akin to long-maturity bonds from a duration perspective. Go-go growth stocks and Treasuries make for strange bedfellows, no matter how logical the earnings-stream reasoning may appear to be at first glance, and we view the application of duration concepts to equities as a stretch in any event. In this Special Report, we make the case that the recently observed tight inverse correlation between relative Tech sector performance and the 10-year Treasury yield is anomalous and should not be expected to persist. Right Church, Wrong Pew Duration is the weighted-average term to maturity of a bond’s cash flows and describes its price sensitivity to changes in interest rates. It is an essential feature of fixed income markets but attempts to extend the concept to equities necessarily fall flat. Bondholders receive interest and principal payments subject to a contractually fixed schedule that makes valuing a bond, especially one with negligible credit risk, a simple exercise in arithmetic. The present value of any bond (PV) is equal to the sum of its discounted series of cash flows, as in the equation Chart , where x = one of a series of n semi-annual payments, r = the discount rate and t = the time in years when the next payment will be received. Chart 1 Assuming that all the interest payments and the principal payment will be received on time, the only variable term in the bond present value equation is the discount rate, r. As r appears solely in the denominator, a bond’s present value is inversely related to its moves. The cash streams accruing to stockholders are inherently unpredictable, however, and the present value of an equity interest is subject to fluctuations in the realized and estimated future values of x as well as changes in discount rate r. Forces that move r may or may not also move x and it is uncertain whether the numerator or denominator will exert a greater impact if they move together, as they might be expected to do in the case of the high-growth Tech sector. The explanatory power of changes in interest rates weakens as cash flow uncertainty increases. Month-over-month changes in the 10-year Treasury note yield1 explain virtually all the variation in one-month Bloomberg Barclays Treasury Index total returns (Chart 1, top panel). As cash flows become more uncertain with the introduction of modest credit risk, the correlation slips to -40% (Chart 1, middle panel). It weakens even further and flips its sign with equities, which have done better since the financial crisis when the 10-year yield rises than when it falls (Chart 1, bottom panel). Bottom Line: Duration is a metric for measuring bonds’ price sensitivity to changes in interest rates. Because of the uncertain nature of a company’s future cash flows and the multitude of independent variables that influence them, duration is an ill fit with equities. The Post-Crisis Experience The empirical record poses several challenges to the conventional wisdom about Tech stocks and interest rates, beginning with their desultory relationship in the first ten years following the financial crisis. From 2009 through 2018, changes in the 10-year yield are unable to explain any of the variability in relative Tech returns, though they exhibit a tight correlation beginning in 2019 (Chart 2). Tech stocks were utterly indifferent to the yield spikes of 2009 and 2010-11, as well as the sharp intervening decline in 2010, and only began to separate themselves from the field following the Brexit vote, outperforming the overall S&P 500 by 30 percentage points in just two years while the 10-year yield rose from 1.5% to 3%. They then proceeded to blow away the index as yields fell from 2.75% at the end of 2018 to 0.5% at the mid-2020 COVID bottom and have since fought the index to a draw despite a 100-basis point backup above 1.6%. Chart 2Nothing More Than A Lockdown Fling Nothing More Than A Lockdown Fling Nothing More Than A Lockdown Fling In contrast to their all-over-the-map relationship with the level of interest rates, Tech stocks have exhibited a consistently tight fit with relative trailing earnings. A quantitatively inclined visitor from outer space viewing Chart 3 might reasonably conclude that relative Tech stock performance is fully explained by earnings, and all other variables are noise. The series have moved nearly in lockstep with each other and show that Tech’s relative trailing P/E multiple has been quite stable since the crisis. Until relative prices and relative earnings began heading in separate ways as the latter began to slip this Spring, Tech’s relative post-crisis outperformance had entirely been earned, not given. Chart 3Case Closed? Case Closed? Case Closed? Multiples provide an opportunity for interest rate changes to re-enter the discussion. In a direct sense, Tech earnings are comparatively immune to moves in interest rates (the sector’s biggest constituents have immaterial amounts of debt and do not sell big-ticket items that have to be financed), though one might expect the price investors are willing to pay to claim a share of their comparatively backloaded future cash flows may well fluctuate with them. Chart 4, however, shows that the Tech sector’s relative forward multiple has not exhibited a consistent relationship with rates – the correlation between multiples and rates was positive and fairly strong from 2009 through 2018 but weakened and turned negative beginning in 2019. From 1995, when the forward multiple series began, through 2008 (not shown in the chart) the relationship was very weak and negative, generating an r-squared of just 1.4%. Chart 4Defying The Duration Intuition Defying The Duration Intuition Defying The Duration Intuition The relationship between relative four-quarter forward earnings expectations and the 10-year yield sheds some light on how so many observers have been hoodwinked into mistaking correlation for causation. Excepting stretches at the beginning and the end of the 2009-2018 period, when relative forward estimates paid no heed to swings in interest rates, they exhibited a modest negative correlation with the 10-year yield (Chart 5). They moved together with one mind across all of 2020, but that solidarity appears anomalous when viewed against the entire post-crisis record generally and the years that bracket it specifically. In 2018-19, the two years preceding peak pandemic conditions, and 2021, the year following them, Tech’s relative forward earnings expectations have been flatly indifferent to the rate backdrop. Chart 5One-Off One-Off One-Off We submit that the recently observed tight correlation between the 10-year yield and relative forward earnings expectations is an isolated pandemic phenomenon. As bond yields plunged in 2020 due to extraordinary monetary accommodation and fears of a worst-case economic outcome, Tech’s heavy concentration of pandemic winners shot the lights out in terms of actual and projected earnings. Away from the narrow 2020 sample, however, the other twelve years of post-crisis data suggest that there’s no relationship between forward earnings expectations and interest rates. Tech outearned the broader market at a steady rate for the ten years preceding the pandemic without regard for the rates market’s gyrations. Investment Implications Interest rates are a red herring for explaining variations in relative Tech stock performance. The ubiquity of the view that Tech stocks’ relative performance will be heavily influenced by changes in interest rates turns out to be another instance in which something everybody knows turns out not to be true. This finding does not make us Tech bulls; we think the big-picture backdrop is sufficiently mixed to justify our US Equity Strategy and Global Asset Allocation services’ neutral recommendations. We simply wanted to call out the flaws in a popular notion before it becomes even more entrenched. Changes in interest rates do not solely effect equity prices via a denominator effect. They impact the numerator as well. The numerator impacts are multifaceted and vary based on which factor comes to the fore in a given instance. They are much harder to anticipate and therefore hold much more promise for investors who can suss them out in advance. The denominator effect is immediately apparent to any undergraduate who has been introduced to the time value of money and therefore isn’t likely to generate alpha. What’s more, as Tech stocks’ relative performance history illustrates, the relationship between equities and rates is not fixed. The rise of globalization and the Fed’s post-Volcker inflation vigilance ushered in a multi-decade disinflationary trend that ultimately culminated in rampant deflation fears following the global financial crisis. Now that concerns about stagflation have shunted aside concerns about secular stagnation, investors are much less likely to cheer rate backups while wringing their hands over rate declines. As Arthur Budaghyan, BCA’s Chief Emerging Markets strategist, has written, the about-face in market perceptions of interest rates could flip the correlations between equity prices and interest rates from positive (stocks advance as rising interest rates are perceived as evidence of economic improvement) to negative (stocks fall when rates rise and rise when rates fall). Our colleague Jonathan LaBerge, managing editor of the Bank Credit Analyst, has noted that extended valuations increase growth stocks’ vulnerability to rising interest rates. We do not disagree, but they do not have all that much to fear if the backup in Treasury yields is in line with our US Bond Strategy service’s year-end 2021 and 2022 targets of 1.75% and 2-2.25%, respectively. Tech’s outperformance may well have run its course – relative performance is extended, the law of large numbers makes it increasingly difficult to sustain historic growth rates, the legal and regulatory outlook is darkening and a shift from pandemic winners to pandemic losers may be in train – but rising rates alone are not a good basis for trimming Tech exposures.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Duration measures a bond’s sensitivity to a parallel shift in the yield curve, but we use the 10-year Treasury yield as a proxy for the entire curve in our simple regressions of asset class returns against price changes.

Who Likes A Flattening Yield Curve? Who Likes A Flattening Yield Curve? In a recent daily report, we analyzed relative performance of the S&P 500 sectors and styles under different US 10-year Treasury yield (UST10Y) regimes. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the distinct US Treasury yield curve regimes, defined as a three-months change between 10-year and 2-year yields. To analyze sector and style performance by regime, we calculate contemporaneous three-months relative returns of sectors and styles. To summarize the results, we calculate median relative return of each sector/style in each regime. We subtract total period median to remove the sector and style biases in the long-term performance. In a flattening yield curve environment, Defensives, Quality, and Growth tend to outperform, as it indicates scarcity of growth. Accordingly, Real Estate, Technology, Utilities, and Communications Services also outperform. Yield curve steepening is usually associated with growth acceleration. This regime gives boost to more economically sensitive and capex intensive sectors and styles: Value, Small caps, and Cyclicals. Bottom Line: The shape of the US Treasury yield curve will be an important variable to monitor going forward, as it has a substantial effect on relative sector and style performance. ​​​​​​​

Highlights Economy – Everyone from banks to households to businesses is swimming in cash: The Fed’s asset purchases will continue until the middle of next year, but banks, households and businesses already have more cash than they know what to do with. Markets – The flood of liquidity may limit how much rates can rise: The biggest banks have positioned themselves to benefit from rising rates and they are all waiting for somewhat higher yields to begin deploying their excess reserves. Strategy – From the biggest banks’ perspective on the economy, risk assets look like the only place to be: Bank stocks’ relative outlook may be meh, but there’s an enormous amount of dry powder available to support economic activity, credit performance and financial asset prices. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB got the third quarter earnings season off to a good start last week. The stock market wasn’t impressed – the stocks were mixed-to-weaker after reporting – but the big banks handily beat expectations. We think the market got it right, as they didn’t offer much of a reason to be excited about net interest income in the coming quarters, but we don’t study their results and their calls to assess the outlook for their own stocks. We do so to use the banks’ privileged vantage point to gain insight into the broad macro backdrop as revealed by the actions and intentions of households and businesses, borrower performance, lender willingness and the overall state of the financial system. They told a uniformly consistent story this quarter about copious liquidity, which is driving record low credit losses and fueling potent economic growth while continuing to weigh on consumer lending volumes. Difficulty replenishing inventories and a welcoming reception for debt and equity issues have been holding back business borrowing as well. The banks nonetheless saw some signs of life for loan demand in the last month of the quarter and they are optimistic about the consumption outlook. They are eager to lend their still growing hoard of deposits though they are unwilling to direct much of it to securities, preferring to wait for more appealing yields, which they expect are on the way. We heard plenty to affirm our constructive take on the economy through at least the end of next year. Households are spending at a rate that validates our time-release view of fiscal transfers and their incomes are rising enough to keep their checking account balances elevated even though the fiscal flows have largely ceased. Businesses remain flush and can be expected to restock depleted inventories once production and transportation logjams can be untangled. M&A activity is surging, underwriting calendars are full and trading desks have been very busy. When it comes to the banks themselves, the analyst community was focused on net interest income (NII). NII is a function of lending volumes, which will remain subdued in the near term even if they have begun to turn up, and lending margins. The latter can’t expand unless rates rise but the latest yield backup appears to have run its course with the 10-year Treasury yield easing ten basis points to 1.5% in just four sessions last week. An outward shift in the yield curve is what the banks need to outperform the S&P 500 over the rest of the year but their own opportunistic deployment of idle capital as rates rise may prove to be self-limiting. Households Are Spending (Chart 1) … Chart 1Snapback Snapback Snapback [Bank of America consumer customers’ spending] was robust, … up 23% over 2019[.] September was the best month of the year and we’ve seen that spending rate continue through the first part of October. (Moynihan, BAC CEO) [C]ombined debit and credit [card] spend was up 24% versus the third quarter of 2019. Within that data, travel and entertainment spend was up 8% versus 3Q19 and very closely tracked the patterns of the Delta variant …, softening in August and early September, and reaccelerating in recent weeks. (Barnum, JPM CFO) Consumer credit card spending activity continued to increase, up 18% in the third quarter compared to 2019 and 24% compared to 2020. [T]ravel-related spending … remains the only category that has not yet fully rebounded to 2019 levels. (Scharf, WFC CEO) Sales volumes [in credit and debit cards] have been quite strong relative to 2019 and that’s driven by consumer spend. … [S]ales were about 5% higher than 2019 in merchant processing. … Looking at merchant as an example, airline, travel and entertainment are still down quite a bit and probably … flattened a bit in the third quarter, simply because of the Delta variant. But … as [Delta] kind of subsides a bit, we would expect that to start to accelerate again. (Dolan, USB CFO) … And Paying Their Bills, … Net charge-offs this quarter fell again to … 20 basis points of average loans[,] … the lowest loss rate in 50 years. … [The] continued low level of late-stage delinquency loans (Chart 2) … drives the expectation that card losses could decline yet again in Q4 before leveling off. (Donofrio, BAC CFO) [C]onsistent with last quarter, credit continues to be quite healthy. In fact, net charge-offs are the lowest we’ve experienced in recent history. (Barnum, JPM) Chart 2Net Charge-Off Rates May Not Have Bottomed Yet The Big Bank Beige Book, October 2021 The Big Bank Beige Book, October 2021 [C]onsumer balance sheets remain unusually strong on the back of the increase in consumer net worth during the pandemic. (Fraser, C CEO) Consumers’ financial condition remains strong with leverage at its lowest level in 45 years and the debt burden below its long-term average. (Scharf, WFC) Consumer credit performance continued to improve with strong collateral values for homes and autos and consumer cash reserves remaining above pre-pandemic levels. Net [consumer] loan charge-offs declined to 23 basis points. (Santomassimo, WFC CFO) [O]ur net charge-off ratio hit a record low of 20 basis points. … [W]e expect it’s probably going to stay at these lower levels for a few quarters, and then it’s going to start to normalize. [It] probably doesn’t get back to what we would … define as normal, which is kind of 45 to 50 basis points overall, until at least the end of 2022 and probably sometime in 2023. (Dolan, USB) … But They Don’t Yet Need To Borrow (Chart 3) Chart 3US Households Have Built Up A Mountain Of Excess Savings ... US Households Have Built Up A Mountain Of Excess Savings ... US Households Have Built Up A Mountain Of Excess Savings ... [C]hecking customers that had maybe $2,000 or $3,000 in balances with us, they’re sitting with three times what they had before the [pandemic] (Chart 4). … They will spend some of that, I assume, but interestingly enough [their balances have] been growing month-over-month for the last few months. [They’re] not going down even though the stimulus payments … other than childcare stopped. So one thing that bodes well for the economy … is consumer[s] still ha[ve] a lot of money in their accounts and they’re going to spend it. (Moynihan, BAC) Chart 4... And Most Of Them Are Sitting In Checking Accounts ... And Most Of Them Are Sitting In Checking Accounts ... And Most Of Them Are Sitting In Checking Accounts [W]e expect deposit growth to continue, although it’s going to be likely at a slower rate than … so far this year. … You got to remember that … tapering is still QE. So the deposits are not likely to decline until many quarters after QE ends, if they ever do, because as the economy expands, the multiplier effect [could drive] growth in deposits, even though the money supply is coming down. (Donofrio, BAC) [W]hile the [credit card] payment rate is still very elevated, it’s come down from the highs and revolving balances have stabilized. And when we look inside our data, we see evidence of excess deposits starting to normalize in segments of the population that traditionally revolve. So … we’re optimistic about the growth prospects of revolving card balances. (Barnum, JPM) [W]e are encouraged by our household growth and balance sheet trends. However, we expect it to take some time for revolving credit card balances to return to pre-pandemic levels (Chart 5), given the amount of liquidity in the system. (Barnum, JPM) Chart 5A Direct Hit To Net Interest Margins A Direct Hit To Net Interest Margins A Direct Hit To Net Interest Margins [H]ealthy consumer balance sheets and persistently elevated payment rates did mean that loan growth remained under pressure. (Fraser, C) [O]ur customers have significant liquidity, … [with] consumer median deposit balances … up 48% for customers who received federal stimulus and 40% for those who did not. (Scharf, WFC) While payment rates remain high, average [card] balances grew 3% from the second quarter, the first time [they’ve] grown since the fourth quarter of 2020. (Santomassimo, WFC) [W]e’re actually seeing ... credit card balances … start to grow and possibly accelerate as we get into 2022. When you think about customers that are kind of revolving type of customers, … with government stimulus starting to dissipate , … they are going to be looking to credit products … to support their [spending]. … [O]verall, we’re fairly bullish on consumer lending. (Cecere, USB CEO) Ditto Businesses [E]xcluding PPP loans, total … commercial loans grew [at an annualized rate of 11% on a quarter-over-quarter basis] …, but global banking utilization rates are still 700 basis points [below] 2019 [levels]. (Donofrio, BAC) C[ommercial]&I[ndustrial] loans were down 3% [quarter-on-quarter], but up 1% excluding PPP, driven by higher originations. … [C]onsistent with last quarter, we are seeing a slight uptick in utilization rates in middle market and those among larger corporates seem to have stabilized, albeit at historically low levels[,] … consistent with the theme … that the smaller you are and the less likely you are to have benefited from the wide-open capital markets, the more likely you are to be borrowing. We do hear a lot about supply-chain issues from that customer segment [though]. (Barnum, JPM) Corporate client sentiment remains very positive with healthy cash flows and liquidity driving M&A activity and deleveraging. (Fraser, C) Commercial banking loans were up slightly at the end of the third quarter, while line utilization was stable at historic lows. Supply chain difficulties and labor shortages continued to represent significant challenges for our client base. (Scharf, WFC) Commercial credit performance continued to improve and net loan charge-offs declined to 3 basis points. … The commercial real estate [CRE] portfolio has continued to perform well. The recovery in retail and hotel properties reflected increased liquidity and improved valuations. While we have not seen any widespread stress in office, we continue to watch this sector closely and believe that any impact … will take time to play out. (Santomassimo, WFC) [T]he principal challenge in [C&I] is that we continue to see a fair amount of payoffs[.] Where we are seeing nice areas of opportunity … is in asset-backed securitization type of lending [like] warehouse mortgage lines, [and] some supply chain financing activities. … [In the middle-market space,] we are seeing lots of [customer] confidence and relatively strong pipelines. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 6) And Want To Put It To Work (Chart 7) Chart 6All Dressed Up And Nowhere To Go All Dressed Up And Nowhere To Go All Dressed Up And Nowhere To Go Chart 7Borrowers Wanted Borrowers Wanted Borrowers Wanted [Lending] is a customer-driven business and so $900 billion-odd of loans against $2 trillion of deposits is largely driven by customer activity. The good news is you can see in [breakouts of lending by category] what I call the smile chart that the other half of the smile is coming up, meaning that customers are starting to draw on credit and use it and that will bode well for [them] growing their businesses and stuff[.] (Moynihan, BAC) [I]n CRE, we see quite a robust origination pipeline, as we’ve sort of fully removed any pandemic-related credit pullbacks and we’re leaning into that. (Barnum, JPM) [L]ine utilizations remained low and [commercial] loan demand continued to be impacted by low client inventory levels and strong client cash positions. However, there was some increase in demand late in the quarter and period-end balances increased … 1% from the second quarter. (Santomassimo, WFC) [W]e actually saw some growth [quarter-over-quarter] in CRE. The project level, pipelines, things like that are reasonably strong. As we kind of think about the next couple of quarters, though, what we are seeing in the marketplace is pretty strong competition. (Cecere, USB) All Together Now [W]e have a lot of excess liquidity right now, so there’s always an opportunity to deploy some of that in the future. (Donofrio, BAC) [A]t the highest level, … nothing has really changed, meaning we’re still happy to be patient [about deploying excess liquidity into securities.] (Dimon, JPM CEO) [W]e’ve got a lot of liquidity that’s available for us to invest as we see rates increase[.] (Mason, C CFO) As we think about redeployment, we’re still being pretty patient. … [W]e still think that there is more risk to the upside on rates than there is downside at this point. … [W]hen opportunities present themselves, we’ll take advantage of them, … but we’re going to be patient as we see how things develop over the coming months. (Santomassimo, WFC) [We expect] that rates are going to start moving up, at least on the long end, and so we’re trying to be patient and be in a position to be opportunistic when rates are in the right spot. (Dolan, USB) Investment Implications We remain constructive on markets and the economy over the next six to twelve months because of the fundamental support provided by consumers’ embarrassment of riches and our expectation that a meaningful portion of the money sloshing around the economy will bolster financial markets. In keeping with the theme of this Beige Book report, we let participants in last week’s earnings calls make the points in their own words: first, Bank of America CEO Brian Moynihan with the fundamental argument and then an analyst with an insightful question about supply and demand dynamics in the rates market. [The US economy] is led by the American consumer … [and] spending levels are growing at [a] 10% [rate]. That is a tremendous amount of spending that’s going on and it’s accelerating, even as the stimulus is in the rearview mirror by quite a [few] months. So as people get back to work [with] higher wages … , there’s just more money to spend. (Moynihan, BAC) [T]here’s a significant amount of liquidity on bank balance sheets that’s waiting to be put to work, and I’m wondering if that doesn’t put [something of a] cap on how much rates can rise. And then you’re going to have some decline in Treasury issuance because of a declining budget deficit. And then you’re still going to have QE through the first half of next year. So you’ve got a lot of demand for a shrinking supply on the Treasury side. That’s why I’m curious what sort of rate structure you’re anticipating going forward. (Charles Peabody, Portales Partners)   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

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

Recent Portfolio Moves Recent Portfolio Moves Next week we will be holding our quarterly webcast discussing the US equity market outlook. As a brief prologue to the webcast, the following Insight report provides a summary of our recent moves and views. In our latest Strategy Report we posited a cautious outlook for the US margins into the year end. While margins are likely to contract, we don’t expect a bear market in equities. Instead, equities are likely to print pedestrian single digit returns on the back of high valuations, and multiple expansion that “borrowed” returns from the future over the course of 2020. However, the TINA theme is still at play and excess liquidity will hold off a bear market. Even if top line S&P 500 returns remain paltry, money can still be made by granular sector selection and rotation (see chart). Specifically, we recently went overweight Small Caps at the expense of Large Caps as this asset class tends to outperform in a rising rates environment. Bottom Line: While S&P 500 returns are likely to remain in single digits over the coming months, there are plenty of opportunities on the sector level.  

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