United States

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 Chart 2Coal 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 … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken 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 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 Chart 8   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

Dear client, Next week, instead of sending you a Strategy Report, we will be hosting our quarterly webcast “Taper Tantrum 2.0” on Monday, October 18 at 10 am EDT and 9 pm EDT, addressing the recent market moves and discussing the US equity market outlook. Kind Regards, Irene Tunkel   Only time will tell how long the current energy crisis and the resulting bull market in energy equities will last, but a violent snapback is in the cards for crude oil once supply challenges dissipate. Crude oil and the US dollar have historically enjoyed a tight negative correlation (oil, like other commodities, is priced in USD). This relationship has broken down only five times since 2004, with the latest occurrence unraveling right now (see chart, the US dollar shown on an inverted scale). Each break down in the correlation was followed by a correction in energy prices in excess of more than 20% on average. The resolution of the crisis is likely to follow a familiar pattern: Shale producers will ramp up capex spending and drill more wells, which are profitable at the current price level. It is also unlikely that the divergence will close with a downward move in the US dollar, given the Fed’s imminent tapering and rising Treasury rates. Given the explosive spike in energy prices and lack of visibility as to when the crisis will be resolved, we have recently downgraded the S&P energy index from overweight to neutral. Bottom Line: The longer the crisis lasts, the more violent the snapback in WTI and energy equities will be. ​​​​​​​ ​​​​​​​

Highlights As US inflation proves to be not-so-transitory, US interest rate expectations will rise. Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. The net impact from China’s slowdown and higher US interest rate expectations on mainstream EM will be currency depreciation. Rising mainstream EM nominal and real (inflation-adjusted) interest rates do not often lead to domestic currency appreciation A strengthening dollar vis-à-vis EM currencies is bad news for EM fixed-income markets – both local currency bonds and credit markets. Feature This report discusses EM local currency (domestic) bonds and US dollar bonds (credit markets). To begin with, we reiterate our main macro themes since January this year: (1) a slowdown in China and (2) rising US inflationary pressures and higher US bond yields. These macro themes will create tailwinds for the US dollar, at least for the next several months. A strengthening dollar is bad news for EM fixed-income markets. China’s Slowdown China’s slowdown will continue to unfold. China’s credit (TSF1 excluding equity) growth has slowed further in September (Chart 1, top panel). Similarly, household mortgages are also decelerating sharply (Chart 1, bottom panel). Chart 1China's Money And Credit Are Decelerating Chart 2Curtailed Financing For Property Developers = Less Construction Activity     China's ever-important property market and construction activity will contract in the months ahead. Property sales were down by 20% in September from a year ago. Property developers in recent years have been relying on pre-construction sales as a major source of financing. With pre-sales drying up and borrowing restrained by both government regulations and creditors’ unwillingness to lend, property developers will be unable to sustain the current pace of construction and completion (Chart 2). Chart 3Red Flags For EM ex-TMT Stocks For the same reason, property developers have curtailed their purchases of land. Land sales have been a major source of local government revenues – it is estimated to account for 45% of local government revenues including managed (off-balance sheet) funds. The upshot will be that local governments will be unable to ramp up their infrastructure spending to offset shrinking property construction. Altogether, these will have negative implications for the mainland’s industrial economy and raw materials. Notably, global material stocks have rolled over decisively even though CRB Raw Materials price index has yet to peak (Chart 3, top panel). Global industrial stocks in general and machinery stocks in particular have also relapsed. Finally, Chinese non-TMT share prices have dropped by 20% from their February high and EM ex-TMT equity prices have formed a head-and-shoulder pattern, which often precedes a major gap down (Chart 3, bottom panel). These equity market signals are foreshadowing a slowdown in China’s “old economy”. Bottom Line: The shockwaves emanating from the slowdown in China will hinder growth in Asia and commodity-producing economies in the rest of EM. This is positive for the US dollar because among major economic blocks, the US economy is the least exposed to the mainland economy. US Interest Rates Will Be Repriced US bond yields will continue marching higher, supporting the US dollar. The reasons for higher bond yields are as follows: Investors and commentators can differ on their assessment of the US inflation outlook. However, one thing that we should all agree on is that uncertainty over the US inflation outlook is extraordinarily high. Heightened uncertainty requires a higher risk premium in bonds, i.e., a wider bond term premium. Surprisingly, until August, the term premium on US bonds was very subdued (Chart 4). In brief, the US bond term premium will rise to reflect uncertainty around the inflation outlook, which will push bond yields higher. US wages hold the key to the inflation outlook. We believe that wage growth will surprise to the upside as many companies have strong order books but are struggling to hire. As people gradually return to the labor force, employers have a once in a decade chance to attract qualified employees. Hence, companies will likely compete with one another by offering higher wages to attract the most qualified candidates. The job quit rate is the highest it has been since the early 2000s. This rate also points to higher wages (Chart 5). Chart 4High Inflation Uncertainty Heralds Higher Bond Term Premium And Yields Chart 5US Wage Growth Will Accelerate   Three factors that had suppressed US bond yields will likely be reversing: US commercial banks have been major buyers of US Treasurys and agency securities; the US Treasury has depleted its account at the Fed due to the debt ceiling but will now begin issuing more bonds to fill in this account; the Fed has been purchasing $80 billion of US government bonds each month; however, the Fed is preparing to taper and therefore reduce these purchases. Chart 6US Banks Have Been Buying Bonds En Masse US commercial banks’ holdings of US government and agency securities has risen to 19% of their total assets – on par with their early 1990s all-time high (Chart 6, top panel). In turn, the share of loans and leases has fallen to an all-time low (Chart 6, middle panel). As US banks begin to expand their lending, they will likely reduce the pace of their buying of US Treasurys. This along with the US Treasury issuing more paper to increase its depleted Treasury General Account at the Fed (Chart 6, bottom panel) and the Fed’s tapering will likely push up US bond yields. Current shortages are the result of excessive demand, rather than producers operating below capacity.2 The fact is that the supply/shipment of goods is booming, at least from Asia/China to the US. This will prove to be inflationary, and therefore lead to higher bond yields. Chinese shipments to the US continue to thrive – in September, export values were up by 30.5% from a year ago (Chart 7, top panel). Given that US import prices from China are rising at an annual rate of 3.8%, China’s export volume to the US has grown to about 26.7% from last September when it was already booming. Consistently, inbound containers unloaded at the Long Beach and LA ports have surged to all-time highs (Chart 7, bottom panel). Hence, US ports are not operating below capacity, it is excessive demand for goods that has created these bottlenecks. Finally, concerning semiconductors, shortages are due to excessive demand not a failure to produce. Global semiconductor production has been growing rapidly over the past two years. A silver lining is that a capitalistic system will eventually expand production and meet demand. Although we broadly agree with this expectation, it will take a couple of years for this to take place. In the interim, we can expect to see higher prices, at least for goods, and rising inflation expectations. Bottom Line: As US inflation proves to be not-so-transitory, US interest rate expectations will rise, which will support the US dollar. The broad-trade weighted US dollar has been correlated with US TIPS yields (Chart 8). Chart 7Shipments From Asia To The US Have Been Booming Chart 8High US Rates Will Support The Dollar   EM Domestic Bonds Chart 9EM Inflation Has Been Spiking EM domestic bond yields have been rising as inflation in EM ex-China, Korea, Taiwan (herein referred as mainstream EM) has been surging (Chart 9). Even if commodity prices roll over, EM interest rate expectations will likely continue rising for now because of higher US bond yields and EM currency weakness. Many clients have been asking whether rising mainstream EM policy rates and local bond yields will support EM currencies. We do not think so. In high-yielding interest rate markets such as Brazil, Mexico, South Africa, Russia and Turkey, neither short- nor long-term rates have been positively correlated with the value of their currencies (Chart 10 and 11). Chart 10Higher Bond Yields Do Not Lead To Currency Appreciation In Brazil And Mexico Chart 11Higher Bond Yields Do Not Lead To Currency Appreciation In Russia And South Africa Chart 12Higher EM Inflation-Adjusted Bond Yields Do Not Lead To EM Currency Appreciation Further, in these markets real (inflation-adjusted) rates also have not been positively correlated with their currencies (Chart 12). As illustrated in Charts 11, 12 and 13, there has been no positive correlation between both EM nominal and real (inflation-adjusted) interest rates and their currencies. Rather, there has often been a negative correlation. The basis is that exchange rates drive interest rate expectations, not vice versa. Currency depreciation leads to higher inflation expectations and rising interest rates. Conversely, exchange rate appreciation dampens inflation expectations paving the way for declining interest rates. Bottom Line: The net impact China’s slowdown and higher US interest rate expectations on mainstream EM domestic bonds will be currency depreciation with little room for their central banks to cut rates. As a result, local bonds’ risk-reward factor remains an unattractive tradeoff. EM Credit Markets As we laid out in A Primer on EM USD Bonds report  on April 29, EM exchange rates and their business cycle are the key drivers of EM sovereign and corporate credit spreads. If EM currencies drop, EM sovereign and corporate credit spreads will widen (Chart 13). The basis is that foreign currency debt servicing will become more expensive as EM currencies depreciate. As EM growth disappoints, EM credit spreads will widen too (Chart 14). Chart 13EM Credit Spreads And EM Currencies Chart 14EM Profit Expectations And EM Corporate Spreads   In addition, the continuous carnage in Chinese offshore corporate bonds will heighten odds of a material selloff in this EM credit. Chinese property companies’ USD bonds make up a more than half of China’s offshore USD corporate bond index and a large part of the EM corporate bond index. Poor performance of the EM corporate bond index could trigger outflows from this asset class. Investment Recommendations Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. As the interest rate differential between China and the US narrows, the CNY will likely experience a modest setback versus the greenback (Chart 15). Even small RMB weakness could produce a non-trivial depreciation in EM exchange rates. The latter is negative for EM local currency bonds and EM credit markets. Absolute-return investors should stay on the sidelines of EM domestic bonds. For dedicated investors in this asset class, our recommended overweights are Mexico, Russia, Korea, India, China, Korea, Malaysia and Chile. EM credit markets will continue to underperform their US counterparts (Chart 16). Credit investors should continue underweighting EM credit versus their US counterparts, a strategy we have been recommending since March 25, 2021. Chart 15CNY/USD And The Interest Rate Differential Chart 16EM Credit Markets Are Underperforming Their US Peers   Finally, EM ex-TMT share prices correlate with inverted EM USD corporate bond yields (Chart 17). Higher EM corporate bond yields (shown inverted in Chart 17) entail lower EM ex-TMT share prices. Chart 17High EM USD Bond Yields Herald Lower Share Prices In turn, China’s TMT stocks remain vulnerable as we have argued in past reports. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Total Social Financing. 2 We made a similar case for Chinese electricity shortages in last week’s report. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Spread Product: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market & Fed: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. The Treasury curve will bear-flatten as that outcome is priced in. Duration: Investors should maintain below-benchmark portfolio duration with an expectation that the 10-year Treasury yield will reach a range of 2%-2.25% by the time of Fed liftoff in December 2022. Feature Chart 1A December Debt Ceiling Debate The creditors of the United States government can breathe a little easier, at least for a couple of months, as Congress reached an agreement last week to punt debt ceiling negotiations until December. T-bills maturing this month reacted sharply to price-out the risk of technical default, though December bill yields have already started to push higher in anticipation of more turmoil (Chart 1). Of course, the political incentives to lift the debt ceiling will be the same in December as they are today, and Congress will ultimately act to avert economic disaster.1 Financial markets seem to realize this, and Treasury note and bond yields have been unphased by the drama. Instead, Treasury yields have moved higher in recent weeks alongside other indicators of optimism surrounding economic reflation and re-opening (Chart 2). However, there is one troubling signal from financial markets that warrants further investigation. Corporate bonds (both investment grade and high-yield) have underperformed duration-matched Treasuries so far in October, even as Treasury yields have moved higher (Chart 3). Typically, Treasury yields and corporate bond spreads are negatively correlated – spreads tighten as Treasury yields rise, and vice-versa – so it is notable when the correlation flips. Chart 2The Reflation Trade Is Back Chart 3Bad Times For Bonds   The next section of this report explores the economic drivers of the yield/spread correlation and considers whether the flip to a positive yield/spread correlation signals anything about future corporate bond performance. An Examination Of The Yield/Spread Correlation The simple economic explanation for the negative yield/spread correlation is that an improved economic outlook leads to both a better environment for credit risk (i.e. tighter corporate bond spreads) and the expectation that higher interest rates will be needed to cool the economy in the future (i.e. higher Treasury yields). With that in mind, when spreads and yields both rise at the same time it usually means that the Fed is “over-tightening”. That is, tightening monetary policy so much that the near-term credit environment is deteriorating. This could be because the Fed is making a policy mistake – tightening into an economic slowdown – or because inflation is high enough that the Fed is deliberately slowing growth in an effort to bring down prices. A Technical Examination Looking at the history of monthly changes in Treasury index yields and High-Yield index spreads since 1994, we see that it is quite unusual for yields and spreads to both rise in the same month (Chart 4). In fact, monthly yield and spread changes are negatively correlated 65% of the time and have only risen together in 15% of the months since 1994. Chart 4Monthly Junk Spread Changes Versus Monthly Treasury Yield Changes Since 1994 Second, we observe in Chart 4 that almost all months of large spread widening or tightening occur against the back-drop of a negative yield/spread correlation. This shouldn’t be too surprising. The worst months for corporate bond performance occur during economic recessions when the Fed is cutting interest rates. Conversely, the best months for corporate bond performance occur just after the recession-peak in spreads when the Fed has finished cutting rates and the economic recovery is starting up. Tables 1A and 1B delve deeper into the return numbers. Table 1A shows average High-Yield excess returns over different investment horizons following a signal from the yield/spread correlation. For example, the second row shows that after a month when both Treasury yields and junk spreads rise, high-yield bonds deliver average excess returns of 24 bps during the following 3 months, 116 bps during the following 6 months and 75 bps during the following 12 months. Table 1B provides even more detail by showing 90% confidence intervals for each number. Table 1AAverage High-Yield Excess Returns After A Signal From Yield/Spread Correlation Table 1BHigh-Yield Excess Returns After A Signal From Yield/Spread Correlation: 90% Confidence Intervals We draw two conclusions from this analysis. First, a month when spreads widen and yields fall sends the worst signal for near-term (3-month) corporate bond performance, though a month where both yields and spreads rise is a close second. Second, and most relevant for the current market, a month when yields and spreads rise together sends the worst signal for junk bond performance over the following 12 months. In fact, it is the only signal where the 90% confidence interval shows the chance of negative excess returns during the following 12 months. This second conclusion aligns with our intuition. A period of both rising Treasury yields and junk spreads likely signals that the market is pricing-in some move toward a tighter monetary policy stance, though not a severe enough move to send long-maturity Treasury yields down. This is most likely to occur in the very early stages of a monetary tightening cycle, when monetary conditions are still accommodative but recent shifts in Fed policy suggest that they will become more restrictive down the road. A Historical Examination A look back through history confirms our analysis of when yields and spreads tend to rise concurrently. The solid line in the third panel of Chart 5 shows the number of months when both junk spreads and Treasury yields rose out of the most recent trailing 12-month period. The dashed line shows the same measure over the trailing 3-month period, multiplied by 4 to put it on the same scale as the solid line. A spike in these lines indicates that Treasury yields and junk spreads were rising at the same time. Chart 5Rising Yields And Spreads Is A Warning Signal For Monetary Tightening We identify four relevant historical periods. First, yields and spreads rose concurrently during the 1999/2000 Fed tightening cycle. Specifically, yields and spreads rose together in the early stages of the tightening cycle, then spreads continued to widen as yields fell during the 2001 recession. Second, our indicator showed a couple blips higher during the 2004/06 tightening cycle, though corporate bond returns were solid during this period, at least until after the tightening cycle ended and the recession began. Third, the 2013 taper tantrum coincided with a temporary increase in both yields and spreads as investors worried that the Fed was moving too quickly toward rate hikes. Fourth, yields and spreads both moved higher in 2015 as the Fed was heading toward a December 2015 rate hike against a back-drop of slowing economic growth. Turning to today, we view the recent jump in our indicator as similar to the jump seen during the 2013 taper tantrum. Not only is the Fed once again about to taper asset purchases, but the tapering of asset purchases suggests that the Fed’s next move will be a rate hike at some point down the road. We view this as an early warning sign for corporate bond spreads. While the monetary environment remains supportive for positive corporate bond returns for now, this may not be true by this time next year when the Fed is that much closer to liftoff. Bottom Line: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market Update: Still On Track For November Taper And December 2022 Liftoff Chart 6Employment Growth Slowed in September September’s employment report delivered a disappointing headline number, with nonfarm payrolls growing only 194 thousand on the month compared to a consensus estimate of 500k (Chart 6). The details of the report were slightly better: August’s nonfarm payroll growth number was revised higher, our measure of the unemployment rate adjusted for distortions in the number of people employed but absent from work fell from 5.5% to 4.9% (Chart A1) and average hourly earnings rose at an annualized monthly rate of 7.7% (Chart 6, bottom panel). Expect A November Taper For bond investors, the most pressing question is whether the report is bad enough to delay the Fed’s tapering announcement past November. We doubt it. The Fed’s test for when to taper asset purchases, that it gave itself last December, is “substantial further progress” back to pre-COVID levels of employment. Since December 2020, total nonfarm payroll employment is 50% of the way back to its February 2020 level (Chart 7) and there are several good reasons to believe that employment growth will be much stronger in October and November. First, the delta wave of COVID cases clearly weighed on employment growth in September, much like it did in August. The Leisure & Hospitality sector only added 74 thousand jobs in September, compared to an average monthly pace of 349 thousand jobs between February and July of this year before the delta wave struck. With a shortfall of almost 1.6 million Leisure & Hospitality jobs compared to pre-COVID levels (Table 2), job growth in this sector will bounce back sharply during the next few months now that new COVID cases are receding (Chart 8). Chart 7"Substantial Further Progress" Has Been Made Chart 8Delta Wave Has Crested   Second, the last column of Table 2 shows that the government sector accounted for net job loss of 123 thousand in September. This negative number was driven by state & local government education jobs and is almost certainly a statistical artifact. According to the Bureau of Labor Statistics’ release notes: Recent employment changes [in state & local government education] are challenging to interpret, as pandemic-related staffing fluctuations in public and private education have distorted the normal seasonal hiring and layoff patterns. Table 2Employment By Industry Expect December 2022 Liftoff As for what this labor market report means for when the Fed will start lifting rates, we believe that we are still on track for liftoff in December 2022. The Appendix to this report updates our scenarios that show the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and labor force participation rates by specific future dates. If we use the median assumption from the New York Fed’s Survey of Market Participants that the Fed will lift rates when the unemployment rate is 3.5% and the participation rate is 63%, we calculate that average monthly nonfarm payroll growth of +453k is required to reach those targets by the end of 2022. We see that threshold as eminently achievable.2 Bottom Line: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. Investors should maintain below-benchmark portfolio duration and hold Treasury curve flatteners in anticipation of that outcome. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +453k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Footnotes 1 For more details on the politics of the debt ceiling please see US Political Strategy Weekly Report, “The House Ways And Means Tax Plan”, dated September 15, 2021. 2 For a discussion about what unemployment and participation rate targets to use in this analysis please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights In this report, we take a close look at corporate margins by analyzing their key drivers: The general level of economic activity, trends in labor costs and productivity, borrowing costs, tax rates, depreciation charges, the exchange rate, and corporate pricing power. The likely contraction of margins next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth and a decline in corporate pricing power.  In the meantime, the tight labor market is putting upward pressure on wage growth despite a peak in productivity improvement. Input costs are also on the rise with PPI soaring, cutting into corporate profitability. Depreciation is already rising on the back of the recent recovery in capex. Interest expense has bottomed in the face of rising rates, and the potential healing of corporate balance sheets is leading to re-leveraging to raise capital for capex and buybacks.  The US corporate tax rate is bound to increase based on news from Capitol Hill.   The model above encapsulates all of these moving parts (Chart 1) and reiterates that the path of least resistance is lower for US corporate margins. S&P 500 operating margins are likely to contract in 2022. Feature Profits Have Rebounded S&P 500 earnings growth has rebounded vigorously from the pandemic low. Operating earnings-per-share stand 32% YoY above the January 2020 pre-pandemic high (Chart 2). Margins have also exceeded pre-pandemic levels of 11.7% reaching 14.4% in September (Chart 3). The basic story behind a rebound in profitability is well understood: Companies have cut costs aggressively, productivity has improved, lower interest rates have reduced debt servicing burdens, a weaker dollar has boosted overseas earnings, and corporate pricing power has strengthened. Gauging the direction of change for each of these various factors will help us assess whether profits can continue growing, and whether operating margins can continue expanding. Chart 1After An Impressive Surge, Margins Are Set To Decline Chart 2Profits Have Rebounded Vigorously Chart 3Margins Are Above Pre-pandemic High Sneak Preview: We expect profit margins to contract in 2022 NIPA Operating Margins vs S&P 500 Operating Margins The market tends to focus on S&P 500 earnings and these can be measured on a reported or operating basis, with the latter removing the effects of one-off charges. In order to better understand the path of S&P 500 margins, we aim to relate profits to the economic cycle; to do so, we analyze the data from the national income and product accounts (NIPA) because they are fully integrated with GDP and any related series. National non-financial after-tax profits without the inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj)1 are conceptually closest to S&P 500 profits as they measure the after-tax worldwide earnings of US corporations. Fortunately, the S&P and equivalent national income measures of operating profits broadly track each other over the long run, although the S&P data display greater volatility. The NIPA profit margin series is 70% correlated with S&P 500 operating profit margins. While this level of correlation indicates that long-term trends in NIPA profits and S&P earnings are broadly similar, short-term annual and quarterly growth rates can differ dramatically. The Key Drivers Of Profitability A number of factors can influence the path of profits: The general level of economic activity, including trends in borrowing costs, tax rates, depreciation charges, the exchange rate, productivity, and corporate pricing power. It clearly would be most bullish if productivity had been the main driver because any future benefits from the other four sources will be limited. Interest rates will normalize at some point, and effective tax rates seem more likely to rise than fall from current levels, and we should hope for faster depreciation in line with increased capital spending. In addition, the downside in the dollar is constrained by the desire of other countries to maintain competitive exchange rates. Corporate pricing power is the sole mitigating factor against these cost pressures. In this report, we will methodically go through and assess the outlook for each of these profit drivers, and their cumulative effect on profit margins for the next year or so. Revenue Growth Is A Key To Margin Expansion The EBITD measure of domestic non-financial profits excludes the impact of changes in taxes, interest rates and depreciation charges and is thus the series that is most directly affected by the underlying economic cycle and by productivity. Moreover, because it covers only domestic profits, it is not overly influenced by exchange-rate movements. GDP growth and NIPA EBITD margin expansion move in tandem. The post-pandemic rebound in economic growth has underpinned margin recovery (Chart 4). However, real GDP forecasts have recently been cut from 6.5%  to just under 6% for 2021, and to 4% in 2022 (Chart 5). Slower growth suggests that the pace of margin expansion will also slow. Chart 4EBITD Margins Usually Track GDP Chart 5GDP Growth Is Expected To Slow Cost Drivers Of Profits Labor Expense As Percentage Of Sales Has Been Falling Looking at the expense side of the NIPA Income Statement, we note that labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items (Chart 6). The NIPA EBITD margin allows us to gauge the effect of changes in labor costs on the bottom line.  Chart 6Labor Costs Are The Largest Expense After the initial spike to 54% of sales at the beginning of the pandemic, explained by rapidly falling sales and an inability of companies to rapidly reduce employee numbers, labor costs as a percentage of sales have been reverting to historical levels.  This is a curious phenomenon as wages have recently been on the rise: The number of open positions has been exceeding the number of job seekers by over a million, indicating that jobs are plentiful.  As a result, the quit rate has exploded (Chart 7). To attract and retain workers, businesses have been raising compensation, leading to average weekly earnings rising by more than 5% year over year. As a result, wages-to-sales have been trending up (Chart 8). Chart 7Quit Rate Exploded Pushing Wages Up Chart 8Wages-to-Sales Have Been Trending Up If companies must pay more for labor, why has the labor expense as percentage of sales fallen? To answer this question, we will look at the selling prices over unit labor costs as a proxy for the EBITD margin (Chart 9) to examine the underlying profitability as a function of labor costs. However, since the beginning of the pandemic, this stable relationship has broken down, with selling prices falling over unit labor costs, while margins have been expanding. Digging deeper, we notice that NIPA sales prices have rebounded (Chart 10) due to a surge in inflation and a rise in a corporate pricing power (Chart 11), while unit labor costs dived. This can be attributed to a pandemic productivity surge (Chart 12), making it cheaper to produce each additional unit.  Chart 9A Proxy For EBITD Margin Chart 10Sales Prices Are Up, Unit Labor Costs Are Down Chart 11US Corporate Power Is Waning Chart 12Productivity Has Peaked However, after rising for months, the ability of companies to raise prices further has been diminished by consumers’ income increasing slower than inflation, reducing their purchasing power.  Improvements in productivity have also peaked and are unlikely to propel margins higher.  Input Costs Are Soaring While cost of goods sold (COGS) is not one of the lines in the NIPA income statement, we would be remiss not to mention that input costs have been on the rise. The most recent reading in PPI was up 8.3% YoY (Chart 13). The price of oil has been surging as well. An increase in the cost of materials definitely has an adverse effect on corporate margins. We will quantify the effects of the year-on-year percentage of PPI on margins later in this report. Chart 13Input Prices Have Soared Other Drivers Of Profitability: Depreciation, Interest And Taxes Switching gears to other costs, interest, taxes, and depreciation expenses are likely to increase going forward. Capex Is Rising, So Will Depreciation Expense Depreciation expense is the second largest expense in the cost structure, constituting some 15% of sales. Between mid-2009 and mid-2012, depreciation charges fell sharply, curtailed by weak investment growth during the Global Financial Crisis (GFC) economic downturn. Similarly, the same story unfolded during the 2015 manufacturing slowdown, and the pandemic-induced recession (Chart 14). Today, growth in US domestic fixed investment has rebounded at rates comparable to the 2000 and 2010 recoveries. The trend will continue: According to the Philly Fed Manufacturing Survey, capex intentions have been rising (Chart 15). As a result, depreciation expense is set to climb, cutting into margins and earnings. Chart 14Capex Surge Will Lead To Higher Depreciation Chart 15More Capex Is Under Way Interest Costs Set To Increase With Rising Rates Interest charges are small compared to other expenses, never rising above 5% of sales. There has been quite a lot of variability in interest charges in recent years, reflecting swings in both interest rates and the level of corporate borrowing (Chart 16). Falling interest costs provided a boost to profits between 2008 and 2010, as well as during the trade war and the pandemic. Also, corporations have been de-leveraging, but this trend is about to turn: As the corporate sector heals, it is likely to re-leverage, whether to finance capex or buybacks. With interest rates set to rise, interest costs are likely to become a drag on profits (Chart 17).   Chart 16Higher Rates And Corporate Re-Leveraging Will Push Interest Costs Up Chart 17Corporate Debt Has Bottomed Effective Tax Rates Are Likely To Increase Effective tax rates have fallen from about 18% in 2014-2017 to 12% in January 2018 because of the Trump Administration’s tax reform and remain low by historical standards (Chart 18). Meanwhile, taxes paid have also been hit by the 2020 downturn thanks to temporary tax breaks, and have not yet rebounded to pre-pandemic levels, thereby aiding margin expansion. However, given the Biden Administration’s push to increase the US corporate tax rate and eliminate loopholes, chances are that tax expenses will rise. Chart 18Effective Tax Rates Are Low By Historical Standards Overseas Profits So far, we have focused on the domestic drivers of changes in margins.  Yet for many US corporations, especially the ones in the S&P 500, overseas profits are a key source of profits. Many industries derive a substantial share of sales from abroad, and for Technology, this number stands as high as 58%.  Historically, overseas profits have been a tremendous source of growth (Chart 19) thanks to rising exposure to fast-growing emerging economies, a weaker dollar, and the transfer of operations to low-tax regimes. However, recently this trend has turned due to closing loopholes allowing companies to locate headquarters in lower tax regime jurisdictions, tax reform, foreign profits amnesty, and unified global pressure to tax US multinationals. Onshoring of manufacturing production is another emerging trend that is likely to improve the efficiency of supply chains but will add to production expenses, chipping away at corporate profitability. The US dollar has been weakening during the pandemic, giving a boost to profits thanks to both lower prices of the American goods and translation effects (Chart 20). Chart 19Overseas Profits Are Trending Down Chart 20USD TRW Is Strengthening Hence, we conclude that the share of overseas profits is unlikely to change and is not going to become an engine for profit growth for US corporations. Where Next For Profits? The clear implication from the above analysis is that profits have ceased to benefit from earlier benign trends in depreciation charges, interest costs, and tax rates. Looking ahead, these factors, are destined to become modest headwinds for profit growth. Sales growth is also likely to slow as GDP growth returns to trend, with overseas profits less of a source of growth. And importantly, productivity growth and pricing power have peaked and turned, depriving the economy of its key drivers of margin expansion. S&P 500 The obvious question is how all the factors affecting NIPA margins translate into the forecast for change in S&P 500 operating margins. S&P 500 margins are subject to the same profit drivers as the NIPA accounts. In order to forecast the effect of these factors on the year-on-year changes in operating margins, we have built a simple regression model that uses year-on-year changes in average hourly earnings (AHE) to capture the cost of labor; high-yield option-adjusted spreads (OAS) to capture the cost of borrowing; year-on-year PPI as a change in cost of input materials; the trade-weighted USD as an indicator capturing change in foreign profits; and, lastly, the BCA pricing power indicator to measure companies’ ability to pass on these costs to their customers (Table 1).   Table 1Regression To Predict Operating Margins YoY% The model forecast of margin growth peaked in August 2021 and is about to slow into the balance of the year (Chart 21). Margins will contract outright in December 2021-January 2022. The growth rate for margins in January 2022 is -65% year on year.  In January 2021, operating margins were 7.2%. Incorporating a negative year-on-year growth rate, we arrive at margins of only 2.6%, which is certainly very low. The caveat here is that our objective is to predict the direction of change as opposed to working out a point estimate of future margins. In other words, there is a wide confidence interval around any forecast of earnings given the unpredictability of movements in the exchange rate, productivity and the general level of economic activity. However, our assumptions are conservative, and the model clearly points to a margin contraction in 2022. Chart 21After An Impressive Surge, Margins Are Set To Decline And lastly, why will margins contract? What is the main culprit that would make things worse? The answer is an increase in input and labor costs (PPI and AHE), both of which are no longer being offset by a corporate pricing power: The ability of corporations to pass on their costs to customers has diminished, and margins are going to take a hit (Chart 22 & Table 2). Chart 22Increase In Costs Is No Longer Offset By Pricing Power Table 2Contributions To Margins Growth Bottom Line Earnings growth and profit margins are of paramount importance to the performance of equities – as we wrote in a report in August, the key driver of returns has shifted from multiple expansion to earnings growth. Despite the recent pullback, the S&P 500, trading at 20.5x forward multiples, is still expensive. Our analysis shows that S&P 500 operating margins are likely to contract in 2022 because of rising wages, a slowdown in productivity, increases in interest and depreciation expenses, and potential tax hikes. On the revenue side, US GDP growth is slowing, and corporate pricing power is waning, making it difficult to pass on rising costs to customers. Impending margin contraction does not bode well for the strong performance of US equities in the year ahead.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     Profits before tax reflect the charges used in tax accounting for inventory withdrawals and depreciation. The inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj) are used to adjust before-tax profits to NIPA asset valuation concepts. The IVA adjusts inventories to a current-cost basis, which is similar to valuation of inventory withdrawals on a last-in/first-out basis. The CCAdj adjusts tax-reported depreciation to the NIPA concept of economic depreciation (or “consumption of fixed capital”), which values fixed assets at current cost and uses consistent depreciation profiles based on used asset prices. Recommended Allocation