Capex

Special Report

Executive Summary Europe's Largest Import Bill: Oil The EU crossed the Rubicon this week, proposing to eliminate Russian oil imports within six months. The speed of putting the sanctions into effect, and Russia’s retaliation, will be critical to whether the world endures continued inflationary pressures or whether a global recession ensues. Russia indicated it will launch its own round of sanctions in the near future, which could profoundly affect not only global oil and gas markets, but once again induce input price shocks to electricity markets – which will hit firms and households again with higher prices – and agricultural markets. Turmoil in commodity markets has opened a policy debate over whether the world will be forced to migrate to a new monetary order based on access to commodities and control of commodity flows, which would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; and commodity scarcity due to weak capex. Bottom Line: Commodity markets are changing rapidly as fundamentals adapt to supply tightness and an extremely erratic demand recovery.  However, this does not mark the beginning of a new Bretton Woods era.  Markets adapt quickly to changing fundamentals and that will continue. Feature With its proposal this week to ban the import of Russian oil, the EU crossed the Rubicon and now will prepare for an escalation of its economic war with Russia. Oil imports are, by far, the EU's largest energy import expense, and Russia is its largest supplier (Chart 1). Russian natural gas exports to Europe account for 74% of its total natgas exports, although natgas comprises a much smaller share of Russia’s revenue than oil (Chart 2). In a pecuniary sense, oil is far more important, but in an economic sense gas is more meaningful for Europe. Chart 1Europe's Largest Import Bill: Oil Chart 2Russia's Largest Market: Europe Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this that Russia exported, OECD Europe was its largest customer, at 50% of total, according to the US EIA. If Russia's production is curtailed by roughly 1mm b/d this year and next year due to sanctions, we estimate Brent prices could reach $120/bbl. Losing 1.8mm this year and another 700k b/d next year could push Brent prices above $140/bbl (Chart 3). On the natgas side, one-third of the ~ 25 Tcf of Russian production last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 74% – was exported via pipeline to the OECD Europe. These are dedicated volumes flowing through Russia's network into Europe. Until the Power of Siberia pipeline is expanded – likely over the next 2-3 years — this gas will not be available for export. Chart 3Losing Russian Oil Exports Will Push Prices Sharply Higher Oil and gas exports last year accounted for close to 40% of the Russian government's budget. Crude and product revenue last year came in at just under $180 billion, while pipeline and LNG shipments of natgas accounted for close to $62 billion of the Russian government's revenues. Clearly, the stakes are extremely high for Russia if Europe embargoes oil imports. Escalation Of Economic War Russian Energy Minister Alexander Novak last month threatened to shut off Russian exports of natural gas if the EU cut off oil imports. Whether – or how quickly – that threat is acted upon will be critical for Europe. Speculation around the EU's proposal to embargo oil imports of all kinds from Russia centers on the ban becoming effective by the end of this week, with a six-month phase-down of imports.1 It is still possible that the sanctions will be vetoed and revised. But with Germany changing its position and now willing to embargo oil, it is only a matter of time before the majority of the EU cuts off Russian oil imports. In response, Russia will launch its own round of embargoes, which could profoundly affect not only global oil and gas markets, but once again induce input-price shocks to electricity markets – which will hit household budgets and base-metals smelters and refiners – and agricultural markets, given the large share of natgas in fertilizers (Chart 4). It is not difficult to imagine base-metals refining operations closing again in Europe, along with crop-planting delays rising.2 On the back of this collateral damage from the cut-off of Russian oil and gas exports, we would expect inflation and inflation expectations to take another leg up. This comes against a backdrop in which central banks led by the US Fed already have initiated a rate-hiking program to address inflation that is running far hotter than previously forecast. Chart 4Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Power, Fertilizer, Base Metals Could Be Shocked By Russian Cut-Offs Policymakers Reassess Commodities This turmoil in commodity markets has ignited a policy debate over whether the world will be forced to migrate to a new monetary order. The new order, so the argument goes, would be based on access to commodities and control of commodity flows and would replace the fiat-money architecture that succeeded the post-WWII Bretton Woods system. This debate draws together numerous trends – the centrality of commodities to price levels and inflation; central-bank policy; failed regulation at commodity exchanges; non-USD invoicing and funding; and commodity scarcity – particularly in industrial commodities like oil, natgas and metals due to weak capex over almost a decade. The debates around these different crises are being framed around the heightened geopolitical awareness of the critical role of commodities in the language of financial markets. This is a novel innovation; however, it essentially is an argument by analogy and can obfuscate underlying causes and effects. Bretton Woods III In The Offing? Following WW II, the US and other advanced economies launched the Bretton Woods system, under which the US would operate and maintain a commodity-money regime – i.e., the gold standard – that maintained convertability of USD to gold upon demand. This post-World War II Bretton Woods (BW) system – call it BWI – remained in place until the early 1970s and made the USD the preeminent currency in the world during that period. Literally, the system, operated by the Fed, made the USD "as good as gold." That didn't last, as US domestic exigencies – the Vietnam War and the War on Poverty – forced the US to abandon gold-convertibility and adopt a fiat-money system to finance these multiple wars. Nevertheless the dollar retained its centrality to global markets. Call this fiat system BWII. As of 2022, the dollar remains the world’s dominant reserve currency, accounting for ~ 60% of the $12.25 trillion of foreign exchange reserves, according to IMF data (Chart 5).3 As a vehicle currency, it accounts for close to 90% of daily FX trading – amounting to ~ $6 trillion/day of turnover. The dollar also is the preeminent funding and invoice currency. Trade invoicing denominated in USD accounts for 93% of imports and 97% of exports worldwide. Chart 5USD Remains Dominant Reserve Currency According to the WTO, global trade in 2019 (just before the COVID-19 pandemic) was just shy of $19 trillion (Chart 6). This global dominance of the USD means the dollar’s funding-currency role “mediates the transmission of U.S. monetary policy to global financing conditions.”4 This has been the case for the 23 years since the creation of the euro, including the periods before and after the 2008 global financial crisis. Chart 6USD Dominates World Trade The dollar’s importance to the global economy has only grown since the BWI era.5 Obstfeld notes US gross external assets and liabilities relative to GDP “grow sharply (but roughly commensurately) up until the global financial crisis, reaching ratios to GDP in the neighborhood of 150 percent. Since then, assets have levelled off but liabilities have continued to grow.” The dollar faces a range of challenges, as we discuss below, but any discussion must begin with its resilience as the top currency – a resilience that spans the creation of the euro, the rise of China, vast US budget and trade deficits, multiple rounds of quantitative easing, and political instability in Washington. A Return To Commodity-Based Money? The full power of the Fed's role at the center of the global monetary system – as a reserve currency and as the preeminent medium for funding and invoicing trade – was revealed following the invasion of Ukraine by Russia. The US froze Russian foreign reserves, denied it access to the international SWIFT payments system, and imposed sanctions on Russian firms and individuals, and anyone trading with them. Following the US actions, Russia's economy was partially frozen out of global trade, banking and finance. Western partners abandoned their Russian investments, taking their capital and technology out of the country. Outside of the sanctions, individual firms such as refiners, shippers and trading companies “self-sanctioned” their dealings with Russia, and refused to handle inbound or outbound Russian commodities. Given the US capability revealed, and the threat posed to other countries should the US sanction them in a likely manner, new risks to the dollar system will emerge. The primacy of the USD, and the Fed's role in maintaining its central banking position to the world, are by no means assured. Indeed, other states – namely China – will try to insulate themselves from similar sanctions. India is apparently willing to trade with Russia in rubles. Saudi Arabia is exploring being paid in RMB for oil exports to China and a wide range of states could increase their acceptance of RMB at least to cover their growing trade with China. China has been pushing hard to have its RMB recognized and used as a global reserve currency, and a trade-invoicing and trade-funding currency. For this to happen, China also would have to allow its currency to become a vehicle currency – i.e., the anchor leg in FX trading. Zoltan Pozsar, a Credit Suisse analyst, recently penned an article exploring the new terrain exposed by the Russian invasion of Ukraine and the US and EU responses.6 For Pozsar, "Commodity reserves will be an essential part of Bretton Woods III, and historically wars are won by those who have more food and energy supplies – food to fuel horses and soldiers back in the day, and food to fuel soldiers and fuel to fuel tanks and planes today." Pozsar avers that his formulation of Bretton Woods III will reverse the disinflation created by globalization, and "serve up an inflationary impulse (de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left)." These conclusions are similar to conclusions we have reached over the course of the past few years, as it became increasingly apparent that the US was losing geopolitical clout relative to rising powers, mainly China, and that the international system was becoming multipolar and unstable. The Ukraine war confirmed the new environment of Great Power Rivalry. Nation-states will indeed amass and hoard commodities as they will need to gird for battle as this rivalry heats up. Preparation for war and war itself are historically inflationary (Chart 7). Chart 7War And Preparation For War Are Inflationary However, countries still have to pay for commodities in a currency that exporters are willing to receive. Yet the biggest global oil and food exporters depend on the US for their security, except Russia. Even in base metals the US wields extraordinary influence over the non-aligned exporters. These states could reduce their dollar invoicing to cover their share of trade with countries outside the West, but their national security alliances and partnerships imply a hard-to-change view on which economies and currencies will be most stable over the long run. The dollar is again preeminent. China unquestionably wants to diversify away from the dollar. But China’s trade partners will have a limit on how much yuan cash they are willing to hold. If they want to recycle this cash into China’s economy, China must open its capital account. But this would reduce the Communist Party’s control of the domestic economy due to the Impossible Trinity (the yuan would have to float freely). So until China makes this change, the world is stuck in today’s monetary system. By contrast, if China totally closes its system due to domestic or foreign political threats, then the world faces a recession and investors will not be rushing to sell the dollar. For now China is trying to have it both ways: maintaining large foreign exchange reserves while gradually diversifying away from the dollar (Chart 8). China selling off its Treasury holdings and dollar reserves, which began in the aftermath of the Great Recession, is the biggest monetary shift since 1999, when the euro emerged and China’s purchases of Treasuries began to surge due to trade surpluses on the back of its joining the WTO. But there is little basis for China or anyone else to abandon fiat currencies and return to the gold standard. Fiat currencies enable states to control the money supply and hence to try to control their economies and societies. The Chinese are the least likely to abandon fiat currency given their laser focus on employment, manufacturing, and social stability. China is a commodity importer, so that if it seeks to amass commodities as strategic reserves in the midst of a commodity boom, it will pay top price. This means the yuan would need to be kept strong. But in fact China is allowing the yuan to depreciate, as it would face higher unemployment and instability if domestic demand were further suppressed by a rising yuan. China is already undergoing a painful transition away from export orientation – and Beijing has already acknowledged that de-industrialization should slow down because it poses a sociopolitical threat (Chart 9). A monetary revolution that strengthens the yuan at the expense of the dollar would force an immediate conclusion to China’s transition away from export-manufacturing. That would be politically destabilizing. Chart 8China Diversifies from USD - But Closed Capital Account Prevents Global RMB Chart 9Stronger RMB Would De-Industrialize China At Great Political Risk If China or other countries attempt to create a commodity base for their currencies, but simultaneously try to prevent a fixed exchange rate that constrains their money supply, then there will be little difference from a fiat currency regime. Today’s major reserve currency issuers already possess reserves of physical wealth (e.g. commodities) beneath their flexible monetary policy regimes – this dynamic would not inherently change. Of course, Europe, Japan, and the United Kingdom are the leading providers of reserve currencies outside the US and yet they are relatively lacking in commodity reserves. If global investors begin chasing currencies primarily on the basis of commodity reserves, the USD will not suffer the most, as the United States is a resource-rich country. China’s policy and strategy may become clearer after the twentieth party congress this fall, but most likely the current contradictions will persist. China will want to prolong the period of economic engagmeent with the West for as long as possible even as it prepares for a time when engagement is utterly broken. While China knows that the US will pursue strategic containment, and US-China engagement is over, it also knows that European leaders have a different set of interests. They have enough difficulty dealing with Russia and are not eager to expand their sanctions to China. Yet switching from dollar to euro reserves offers China little protection against sanctions in any major confrontation in the coming years. A radical decision by China to buy high and sell low (realize big losses on Treasuries and buy high-priced commodities) would show that Beijing is expecting Russian-style confrontation with the West immediately, which would scare foreign investors away from China. Net foreign direct investment in China has surged since the downfall of the Trump presidency (Chart 10). But that process would reverse as companies saw China going down Russia’s path and disengaging from the global monetary system. In that context, western governments would also penalize their own companies for investing in a geopolitical rival that was apparently preparing for conflict (while buttressing Russia). In short, private capital will flee countries that abandon the global financial system because that would be an economically inefficient decision taken for reasons of state security, and hence it would imply higher odds of conflict. Wealthy nations see China’s and other emerging markets’ foreign exchange reserves as “collateral” against asset seizures and geopolitical risks: if China reduces the collateral, private capital will feel less secure flowing into China.7 Chart 10If China Abandonds USD To Prepare For Sanctions, FDI Will Reverse Ultimately China will try to wean itself off the dollar – but it will keep doing so gradually to avoid a catastrophic social and economic change at home and abroad. This is continuation of post-2008 status quo. An accelerated shift away from USD will be interpreted by global actors as preparation for war (just like Russia’s shift). This will drive investors to swap Chinese assets for American or other assets. History suggests that USD devaluations followed US wars and budget expansions. Investors should wait until the next US military adventure, in Iran or elsewhere, before expecting massive dollar depreciation. If the US pursues an offshore balancing strategy, as it appears to be doing today, then other countries will become less stable and the dollar will remain appealing as a safe haven. Bottom Line: Russia’s and China’s diversification away from the dollar over the past decade has not caused global flight from the dollar. International trust in the economy and government of Russia and China is not very high. The euro, the viable alternative to the dollar, is less attractive in the face of the Ukraine war and broader geopolitical instability. The path toward monetary revolution is for China to open up its capital account, make its currency convertible, and sell USD assets while appreciating the yuan. Yet China’s leaders have not embarked on this course for fear of domestic instability. In lieu of that, the current monetary regime continues.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Please see Brussels proposes EU import ban on all Russian oil published by ft.com on May 4, 2022 for summary of the EU's export-ban proposals. 2     Please see our report from March 31, 2022 entitled Germany Closer To Rationing Natgas for further discussion. It is available at ces.bcaresearch.com. 3    See Obstfeld, Maurice (2020), Global Dimensions of U.S. Monetary Policy, International Journal of Central Banking, 16:1, pp. 73-132. 4    Obstfeld (2020, p. 113). 5    Obstfeld (2020, p. 77-78). 6    Please see Pozsar, Zoltan (2022), "Money, Commodities, and Bretton Woods III," published by Credit Suisse Economics. 7     For the “collateral” interpretation of US dollar-denominated foreign exchange reserves, see Michael P. Dooley, David Folkerts-Landau, and Peter M. Garber, “US Sanctions Reinforce The Dollar’s Dominance,” NBER Working Paper Series 29943, April 2022, nber.org.  

Executive Summary The unemployment rate in the US stands at 3.6%, 0.4 percentage points below the FOMC’s estimate of full employment. Historically, the Fed’s efforts to nudge up the unemployment rate have failed: The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Despite this somber fact, there are reasons to think it will take longer for a recession to arrive than widely believed. Unlike in the lead-up to many past recessions, the US private sector is currently running a financial surplus. If anything, there are indications that both households and businesses are set to expand – rather than retrench – spending over the coming quarters. Investors should pay close attention to the housing market. As the most interest-rate sensitive sector of the economy, it will dictate the degree to which the Fed can raise rates. The US housing market has cooled, but remains in reasonably good shape, supported by rising incomes and low home inventories. Stocks will likely rise modestly over the next 12 months as inflation temporarily dips and the pandemic recedes from view. However, equities will falter towards the end of 2023. Stocks Tend To Fare Well When There Is No Recession On The Horizon Bottom Line: The US may not be able to avoid a recession, but an economic downturn is unlikely until 2024. Stay modestly overweight stocks over a 12-month horizon.  Jobs Aplenty The US unemployment rate fell from 3.8% in February to 3.6% in March, bringing it close to its pre-pandemic low of 3.5%. Adding job openings to employment and comparing the resulting sum with the size of the labor force, the excess of labor demand over labor supply is now the highest since July 1969 (Chart 1). Chart 1Labor Demand Is Outstripping Labor Supply By The Largest Margin Since 1969 Granted, the labor force participation rate is still one full percentage point below where it was prior to the pandemic. If the participation rate were to rise, the gap between labor demand and supply would shrink. Some of the decline in the participation rate is permanent in nature, reflecting ongoing population aging, which has been compounded by an increase in early retirements during the pandemic (Chart 2). Some workers who dropped out will probably re-enter the workforce. Chart 3 shows that employment among low-wage workers has been slower to recover than for other groups. With expanded unemployment benefits no longer available, the motivation to find gainful employment will escalate. Chart 2Not All Of The Decline In Labor Participation During The Pandemic Was Due To Increased Early Retirements Chart 3Low-Wage Workers Have Not Returned In Full Force Nevertheless, it is doubtful that the entry of low-wage workers into the labor force will do much to reduce the gap between labor demand and supply. Low-wage workers tend to spend all of their incomes (Chart 4). Thus, while an increase in the number of low-wage workers will allow the supply of goods and services to rise, this will be counterbalanced by an increase in the demand for goods and services. Chart 4Richer Households Tend To Save More Than Poorer Ones To cool the labor market, the Fed will need to curb spending, and that can only be achieved by raising interest rates. Trying to achieve a soft landing in this manner is always easier said than done. The US has never averted a recession when the 3-month average of the unemployment rate has increased by more than a third of a percentage point. Rising unemployment tends to produce a negative feedback loop: A weaker labor market depresses spending. This, in turn, leads to less hiring and more firing, resulting in even higher unemployment. Where is the Choke Point? How high will interest rates need to rise to trigger such a feedback loop? Markets currently expect the Fed to raise rates to 3% by mid-2023 but then cut rates by at least 25 basis points over the subsequent months (Chart 5). So, the market thinks the neutral rate of interest – the interest rate consistent with a stable unemployment rate – is around 2.5%. The Fed broadly shares the market’s view. The median dot for the terminal Fed funds rate stood at 2.4% in the March Summary of Economic Projections (Chart 6). When the Fed first started publishing its dot plot in 2012, it thought the terminal rate was 4.25%. Chart 5The Markets See The Fed Funds Rate Reaching 3% Next Year Chart 6The Fed's Estimate Of The Terminal Rate Has Fallen Over The Years Low Imbalances Imply a Higher Neutral Rate We have discussed the concept of the neutral rate extensively in the past, so we will not regurgitate the issues here (interested readers should consult the Feature Section of our latest Strategy Outlook). Instead, it would be worthwhile to dwell on the relationship between the neutral rate and economic imbalances. Simply put, when an economy is suffering from major imbalances, it does not take much monetary tightening to push it over the edge. The private-sector financial balance measures the difference between what households and firms earn and spend. A recession is more likely to occur when the private-sector financial balance is negative — that is, when spending exceeds income — since households and firms are more prone to cut spending when they are living beyond their means. In the lead-up to the Great Recession, the private-sector financial balance hit a deficit of 3.9% of GDP in the US. Leading up to the 2001 recession, it reached a deficit of 5.4% of GDP. Today, the US private-sector financial balance, while down from its peak during the pandemic, still stands at a comfortable surplus of 3% of GDP. Rather than looking to retrench, households and businesses are poised to increase spending over the coming quarters (Chart 7). Private-sector financial balances are also positive in Japan, China, and most of Europe (Chart 8). Chart 7Consumers And Businesses Are Set To Spend More Chart 8Private-Sector Financial Balances Are Positive In Most Major Economies Watch Housing Chart 9Rising Interest Rates In The Early 1980s Had Much More Of A Negative Effect On Housing Than Business Investment At the 2007 Jackson Hole conference, Ed Leamer presented what turned out to be a very prescient paper. Titled “Housing is the Business Cycle,” Leamer concluded that “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.” Housing is a long-lived asset, and one that is usually financed with debt. To a much greater extent than nonresidential investment, the housing sector is very sensitive to changes in interest rates. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 9). The jump in mortgage yields has started to weigh on housing (Chart 10). Mortgage applications for home purchases have fallen by 25% from their highs. Pending home sales have dropped. Homebuilder confidence has dipped. Homebuilder stocks are down 29% year-to-date. Housing is likely to slow further in the months ahead, even if mortgage yields stabilize. Chart 11 shows that changes in mortgage yields lead home sales and housing starts by about six months. Chart 10The Jump In Mortgage Rates Has Weighed On The Housing Market Chart 11Swings In Mortgage Rates Explain Short-Term Fluctuations In Housing Activity The key question for investors is whether the housing market will enter a deep freeze or merely cool down. We think the latter is more likely. The 30-year fixed mortgage rate has increased nearly two percentage points since last August, but at around 5%, it is still below the average of 6% that prevailed during the 2000-2006 housing boom (Chart 12). Moreover, unlike during the housing boom, when homebuilders flooded the market with houses, the supply of new homes remains contained. The nationwide homeowner vacancy rate stands at record lows. Building permits are near cycle highs (Chart 13). Granted, real home prices are close to record highs. However, relative to incomes, US home prices have not broken out of their historic range (Chart 14). Chart 13The Homeowner Vacancy Rate Is Near Record Lows Chart 14Homes In The US Are Relatively Cheap Home affordability is much more stretched outside of the United States. The Bank of Canada, for example, has less scope to raise rates than the Fed. Chart 15Some Signs Of Easing In Supply-Side Pressures Investment Conclusions As investors, we need to be forward looking. The widespread availability of Paxlovid later this year — which, in contrast to the vaccines, is effective against all Covid strains — will help boost global growth while relieving supply-chain bottlenecks. Shipping costs, used car prices, and ISM supplier delivery times have already come down from their highs (Chart 15). Central banks have either started to raise rates or are gearing up to do so. However, monetary policy is unlikely to turn restrictive in any major economy over the next 12 months. Stocks usually go up outside of recessionary environments (Chart 16). Global equities are trading at 17-times forward earnings. The corresponding earnings yield is about 630 basis points higher than the real global bond yield – a very wide gap by historic standards (Chart 17). Chart 16Stocks Tend To Fare Well When There Is No Recession On The Horizon Chart 17AThe Equity Risk Premium Remains Elevated (I) Chart 17BThe Equity Risk Premium Remains Elevated (II) Investors should remain modestly overweight equities over a 12-month horizon and look to increase exposure to non-US stock markets, small caps, and value stocks over the coming months. Government bond yields are unlikely to rise much over the next 12 months but will increase further over the long haul. The dollar should peak during this summer, and then weaken over the subsequent 12 months. A complete discussion of our market views is contained in our recently published Second Quarter Strategy Outlook.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Copper Will Remain Tight Even In Recession Supply-chain disruptions arising from Russia's invasion of Ukraine and demand hits from lockdowns in Shanghai are increasing the odds of a global recession, which can be seen in the WTO's latest economic forecast. Cyclical base-metals demand, particularly copper's, will slow in a recession. Still, markets will remain physically short and well bid, as incremental demand from the global renewable-energy and defense buildouts gathers strength. Global GDP growth will return to trend in 2024. Renewables and defense-related demand will continue to power ahead. Physical deficits will persist. Copper-supply growth increasingly is tied to local political risk – e.g., Chile's government sued miners over water-use disputes this month. Miners now are seeking assurances investment will be protected before committing to higher capex. The environmental stain arising from the global competition for metals will redound to the benefit oil and gas E+Ps involved in natural gas and hydrogen production. Bottom Line: A higher likelihood of a global recession will not diminish the drive to secure base metals critical to renewables and defense, particularly copper. This will keep metals bid and inventories strained. Stagflation likely ensues. We remain long commodity-index exposure expecting longer-term backwardation, and ETFs with exposures to the equity of miners. We continue to expect copper prices to average $5/lb on the COMEX this year, and $6/lb in 2023. Feature The World Trade Organization (WTO) released a sharply lower expectation for global growth this week – from a robust 5.7% rate in 2021 to 2.8% this year and 3.2% next year.1 This effectively translates into a global recession arriving this year. The WTO forecast also calls for global merchandise trade volume to grow 3.0% in 2022 and 3.4% in 2023, which also will dampen cyclical aluminium demand. Related Report  Commodity & Energy StrategyCopper Will Grind Higher The WTO's forecast is one of the first among major agencies to incorporate the impact of the Ukraine war and supply-chain disruptions arising from lockdowns in Shanghai. If the WTO's forecast is realized, cyclical copper and base metals demand will slow, but markets will remain physically short – i.e., in deficit – and well bid, in our view (Chart 1). Incremental demand from the global renewable-energy and defense buildouts in the Big 3 military-industrial blocs – the EU, US and China – will gather strength and keep metals markets tight over the course of this decade (Chart 2). Chart 1Copper Will Remain Tight Even In Recession Chart 2Copper Inventories Will Remain Tight Global refined copper demand is highly sensitive to GDP growth: While not exactly a 1-for-1 correspondence, a 1% increase in global GDP translates into a 0.76% increase in refined copper demand. A 1% increase in EM GDP translates into a 0.54% increase in refined copper demand in these economies (Chart 3). Interestingly, our modeling finds DM GDP growth has had little if any effect on global refined copper demand, most likely because, historically, DM economies were not building infrastructure to the extent EM economies, particularly China and the Asian Tigers, has been building over past decades. Chart 3World, EM GDP Drive Copper Demand Estimating New Incremental Copper Demand The DM base metals demand profile – particularly for copper – is set to change dramatically following the Russian invasion of Ukraine. Russian aggression prompted the EU to double-down on its renewable energy build-out, and to restore a credible military to protect its borders and the safety of its citizens. Both of these efforts will be funded by new bond-issuance programs from the EU. Practically, this means the EU will join the US and Chinese military-industrial complexes in the global competition for critical materials required for the renewable-energy and defense buildouts. The EU and China already were active on the renewables side; it is the US that will be joining that race on a larger scale following the passage of legislation by the Biden administration to fund and incentivize renewables.2 The US and China have been in an intense competition to build military capacities; now the EU joins that race. None of these military-industrial complexes will provide actual spending estimates for these buildouts, which means markets have to continually revise their supply-demand estimates for base metals as data becomes available. Copper markets provide the best data for such an exercise – it is the bellwether market for base metals, with useful data to estimate supply and demand. As a starting point for our estimation of copper balances going forward, we assume global cyclical demand will remain a function of global GDP; EM demand also can be modelled using EM GDP as an explanatory variable. We also assume that the 10 years ending in 2030 will require refined copper production to double in order to meet demand for renewable-energy and from the military-industrial complex globally. We make some reasonable first approximations of what this will look like initially, and then will iterate as actual data becomes available. Chart 1 shows the evolution we expect for global consumption as a function of cyclical and incremental demand. On the supply side, we use estimated annual production for refined copper production from the Australian government's Department of Industry, Science, Energy and Resources, and the World Bureau of Metals Statistics. We note there are a few noteworthy projects due to come on line – e.g., Canada (Kena Gold-Copper project; Blue Cove Copper Project); Congo (Kamoa-Kakula project ramping up); Peru (Quellaveco) and Chile (Pampa Norte). We again note that copper supply in critically important states accounting for huge shares of global production – e.g., Chile (30% of global mining output) and Peru (10%) – increasingly is vulnerable to local political risks.3 Chile, in particular, is facing environmental and political challenges on the mining side: It is in the 13th year of a drought, which forced the government to institute water rationing in the capital Santiago this week. In addition, last week the federal government sued major mining companies over water-rights disputes. Our price view will evolve as we get data on cyclical and incremental demand, and supply additions.We would note in this regard major miners already are sounding the alarm on how difficult it will be to lift supply over the next 10 years given the likely demand markets will be pricing in. For now, we are maintaining our expectation COMEX copper prices will average $5/lb this year and $6/lb next year, and that markets will remain backwardated with inventories remaining under pressure (Chart 2).4 Investment Implications Base metals markets – copper included – are facing a moment of reckoning in terms of being able to support the global push for renewable energy. While the odds of a global recession in the wake of Russia's invasion of Ukraine and China's lockdowns to address the COVID-19 outbreak in Shanghai are higher – which ordinarily would point to inventory accumulation, all else equal – we believe markets will remain tight. A recession will cause cyclical demand to soften, which, along with marginal new supply, will keep the COMEX forward curve relatively flat over the short term (3-9 months). However, over the next two years and beyond, supply will not be coming on fast enough to offset cyclical and incremental demand from the global renewables and defense buildouts (Chart 3). This will keep copper markets in physical-deficit conditions, and inventories will have to draw to meet demand (Chart 4). We expect this will translate into renewed backwardation in the COMEX forward curve. Chart 4Global Inventories Will Continue To Draw Chart 5Backwardation Will Re-emerge We remain bullish copper over the medium and longer terms, and remain long commodity index exposure expecting a return of backwardation in COMEX copper, and the XME ETF, which gives us exposure to base metals miners (Chart 5).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish US LNG exports hit record highs again in March, continuing a streak that began in December 2021. Exports averaged 11.9 Bcf/d for the month, on the back of new liquefaction capacity coming on line at the beginning of March. The US EIA is expecting LNG exports to average 12.2 Bcf/d this year, which would represent a 25% increase in shipments abroad. This US is accounting for the bulk of European LNG exports at present. European storage ended March at 26% of capacity, vs. a five-year average capacity of 34% at end-March. Separately, China became the largest importer of LNG in the world in 2021, displacing Japan for the top spot. According to the EIA, China’s LNG imports averaged 10.5 Bcf/d last year, which was close to 20% above 2020 levels. China's LNG imports exceeded Japan's , a 1.7 Bcf/d (19%) increase over its 2020 average, and 0.8 Bcf/d more than Japan’s imports. Base Metals: Bullish The Fraser Institute released a report assessing states’ and countries’ mining investment attractiveness for 2021. Investment attractiveness is measured by accounting for the mineral availability in the region and the effect of government policy on exploration investment. Western Australia topped the charts, while the copper-rich nations of Chile and Peru ranked 38th and 49th. This is telling of the policy adversity and uncertainty towards mining in these two countries and resonates with a BHP executive’s remarks a few weeks ago. Last week, the Chilean government sued mines operated by BHP, Albemarle, and Antofagasta over alleged environmental damage. One of the mines sued is BHP’s Escondida, the world’s largest copper mine. Precious Metals: Bullish According to Impala Platinum, palladium and rhodium prices are expected to rally for the next four-to-five years on tight market fundamentals. Low palladium supply coupled with an increase in the metal’s demand for catalytic converters, as pollution control regulations tighten, are causing the supply squeeze. On April 8 London’s Platinum and Palladium Market suspended Russian refiners from minting platinum and palladium for the London market, boosting the price of both metals (Charts 6 and 7). Russia supplies 10% and 40% of global mined platinum and palladium respectively. Depending on the period of the suspension, Europe may need to substitute Russian imports of the metals from South Africa. Chart 6 Chart 7       Footnotes   1     Please see the WTO's "TRADE STATISTICS AND OUTLOOK: Russia-Ukraine conflict puts fragile global trade recovery at risk," released by the WTO on April 12, 2022. Revisions are subject to the evolution of the war in Ukraine following Russia's invasion in February 2022. 2     Worthwhile noting here the Biden Administration in the US invoked the Defense Production Act (DPA) to "to support the production and processing of minerals and materials used for large capacity batteries – such as lithium, nickel, cobalt, graphite, and manganese." In addition, the US Department of Defense will be tasked in implementing this authority. Lastly, the White House readout notes, "The President is also reviewing potential further uses of DPA – in addition to minerals and materials – to secure safer, cleaner, and more resilient energy for America." Practically, the US and China are treating access to critical materials as a defense issue. The EU likely joins this club in the very near future. 3    Please see our report from February 24, 2022 entitled Copper Will Grind Higher for additional discussion. It is available at ces.bcaresearch.com. 4    Please see, e.g., Bigger investment in mining needed to meet climate goals, says LGIM, published by ft.com on  April 5, 2022. The article summarizes a study done by Legal & General Investment and BHP, which notes that without a significant increase in mining activity – which is itself a hydrocarbon-intensive undertaking – there will not be sufficient supplies to achieve the IEA's 2050 net-zero goals.     Investment Views and Themes Strategic Recommendations Trades Closed in 2021  

Executive Summary Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia Chart 4Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth Chart 7Futures Curves For Most Commodities Are Backwardated     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US...​​​​​​ Chart 12... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Chart 33An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued Chart 50Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well Chart 63Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix Special Trade Recommendations   Current MacroQuant Model Scores

Special Report

Executive Summary Oil Remains A Prominent Inflation Variable Tight oil and metals markets will translate into persistently high inflation and inflation expectations over the next 5 – 10 years. High and volatile commodity prices caused by low capex will keep global inventories tight for years.  This will keep the key 5-year/5-year (5y5y) CPI swap rates used by policy makers elevated, given the strong relationship between commodity prices – particularly longer-dated oil prices – and inflation expectations. Central banks will exacerbate this tightness if they follow through on more aggressive policy.  This would increase the cost of capital for commodity producers and could induce a recession.  All the same, commodity supplies still will remain tight, and will keep inflationary pressures emanating from the real economy elevated.  Stagflation is the likely outcome. Gold is lagging as an inflation hedge vs. the average return of our commodity recommendations.  We expect this to persist.  Still, as a safe-haven and store of value during recessionary and inflationary periods, we continue to recommend gold as a portfolio hedge. Bottom Line: The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years.  We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. Feature That's all well and good in practice, but how does it work in theory? - Seen on a T-shirt at the University of Chicago1 Related Report  Commodity & Energy StrategyCommodities' Watershed Moment   Central banks are signaling they expect higher inflation and inflation expectations to persist, and now are communicating their collective resolve to deal with this aggressively, if needs be.2 As central-bank policy evolves, commodities – particularly oil – will become even more important as coincident and leading indicators used to assess the likely course of inflation and inflation expectations, particularly their persistence. The ECB notes oil prices have become more than just one of the input costs of manufacturing, or of mining, agriculture and the production of other forms of energy essential to powering modern economies, and delivering these goods globally. For the ECB, "oil is barometer of global economic activity as well as a financial asset."3 Likewise, the BIS stresses the importance of augmenting conventional Phillips curve models with commodity inputs to more accurately capture inflation dynamics.4 This Special Report follows our earlier report published on March 10, 2022 entitled Commodities' Watershed Moment. Here we explore the consequences of tightening commodity markets, especially as regards inflation and inflation expectations, and attempt to dispel some notions about commodities and markets that could lead to policy errors. We also evaluate our commodity recommendations' performance as inflation hedges compared to gold's performance. Modeling Inflation And Inflation Expectations Our own research and modeling broadly aligns with the ECB and BIS approaches. We periodically estimate cointegrating regressions of inflation expectations using WTI futures prices to forecast 5y5y CPI swap rates (Chart 1).5 Our results are strongest when we use 3-years forward WTI prices to forecast 5y5y CPI swap rates, but shorter-term futures also provide useful information and are cointegrated with inflation expectations discovered in the 5y5y market (Chart 2). The prompt-delivery WTI futures are cointegrated with the longer-dated 3-years forward futures contract, indicating that, over time, these different maturities are following a common long-term trend. This also explains why a similar equilibrium obtains using commodity indexes – the Bloomberg Commodity Index, the S&P GSCI, etc. – as regressors in estimating inflation expectations via the 5y5y CPI swap rates. Chart 1WTI Futures Strongly Linked To US Inflation Expectations Chart 2US Oil Output Slightly Higher Globalization of production, distribution and consumption across markets weaves these markets together – e.g., global fertilizer markets experienced a supply shock this past winter when large consuming markets in Asia and Europe got into a bidding war for limited LNG supplies – and transmits shocks across commodity markets. This partly explains the common long-term trend commodities generally share. Another feature weaving markets together globally is the fact that most global trade is invoiced and funded in USD, which means that the Fed's monetary policy decisions reverberate around the world when rates are increased or dollar liquidity is reduced.6 Lastly, trading markets are global. Commodity markets have evolved – as the ECB notes – into asset markets as well as hedging markets. This means arbitrage across commodity and rates markets (interest rates, inflation rates, FX rates, etc.) accelerates the impounding of information into prices quickly. In this environment, cointegration is strengthened among physical and financial trading markets, creating prices that share long-term equilibria. This makes the current time especially fraught, as the Fed embarks on a policy-tightening course against the backdrop of war in Europe and global commodity shortages. These effects are experienced across geographies and across time, forming a dynamic system in which supply, demand and inventories are constantly adjusting to new information. This affects current and expected fundamentals and financial conditions, which arrives to markets instantaneously. It is not surprising, then, that prices in these markets are, for the most part, cointegrated over the long run.7 Policy Errors Likely On The Way Monetary policy is not well suited to dealing with commodity scarcity. Nor is fiscal policy – e.g., government subsidies to soften the blow of rising energy prices only encourage over-consumption of scarce resources, which accelerates inventory depletion and tightens markets further. The Fed, in particular, likely is reviewing its 1970s playbook for lessons learned in the last major supply shock to hit the world – the Arab Oil Embargo of 1973, which was followed by the Iran-Iraq war in 1979. Together, these events triggered a surge in real oil prices, which rose by 4.5x – from $21.55/bbl in 1970 to $116.11/bbl in 1980, according to the EIA (Chart 3). Chart 3Fed Will Look Back At 1970s Playbook In setting policy, economists generally – at the Fed, the IMF, the World Bank and elsewhere – mistakenly view commodity forward curves as something of a forecast.8 This use of the futures curve is mistaken because it only reflects the price levels as which transactions occurred on any given day. So while a non-specialist might view a backwardated forward curve for Brent as a market-based forecast for lower prices in the future – since prompt prices are trading below deferred prices – a more accurate reading would suggest markets are tight and likely will remain tight. This particular term structure indicates physical inventories are tight, and will remain so until sufficient supply is brought to market to allow refiners to restock. Steep backwardations also predispose markets to higher price volatility, because because of low inventory levels: The market's shock absorber (inventories) is low, so volatility increases.9 Suppose policy makers are counting on lower oil prices – per a forward curve's "forecast" – to bring inflation down. In that case, they likely will be disappointed unless additional supplies arrive. Should the Fed act on the belief that backwardation is a forecast for lower prices and continue to provide forward guidance to markets suggesting inflation will be lower next year, e.g., any delay in its rate hikes will leave it behind the inflation curve. Additional policy errors can come from the fiscal side, for example, when governments provide subsidies to soften the blow of higher oil prices. This retards the function of the price mechanism, and incentivizes higher consumption, which will exacerbate price increases. This would be bullish for oil prices in the short and medium term (6 months – 2 years). Commodity markets are tight globally – at or near scarcity levels in many cases, as can be seen by the continually declining inventories in oil and base metals (Chart 4 and 5). Base metals markets are extremely tight, and are on the back foot – i.e., with physical deficits and low inventories – just as the world's largest economic blocks (EU, US, China) are launching massive buildouts of their renewable-generation fleets and electric grids, and embarking on massive military buildups. These applications will require huge increases in base metals supplies to pull off. Grain markets will tighten as the impact of the Russian invasion of Ukraine unfolds in the spring, when winter wheat crops in Ukraine will need to be fertilized and tended. Chart 4Oil Markets Remain Tight... Chart 5…As Do Metals Barring an extremely deep recession that sharply reduces aggregate demand globally, it is difficult to see how this is not inflationary for years to come. Nonetheless, even a deep recession will still leave markets massively short base metals, and, after core-OPEC producers Saudi Arabia and the UAE bring what left of their spare capacity to market, oil. Investment Implications In days gone by, gold served as a go-to inflation hedge. At present, gold is lagging as an inflation hedge vs. the average return of our direct and equity-related commodity recommendations (Chart 6). We expect this to persist. Gold has performed well against the broad-trade weighted USD, however (Chart 7). We continue to recommend gold as a portfolio hedge, as it remains responsive to policy and geopolitical shocks. And it remains a safe-haven and store of value during recessionary and inflationary periods. Chart 6Commodity Recommendations Outperform Gold Chart 7Gold Outperforms USD The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years, barring a steep recession. Such a turn of events diminishes in probability, as governments keep funneling subsidies to households to soften the blow of higher prices and stave off a recessionary contraction in GDP. These subsidies only succeed in retarding the price signal the market is sending to reduce consumption of scarce commodities, which means available inventories will be drawn down more quickly. We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. These are long-term holdings, given our view the commodities bull market will run for years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see That Works Very Well in Practice, But How Does It Work In Theory? Published by quoteinvestigator.com for a history of how this phrase made it to UChicago's T-shirts. 2     Please see Between A Rock And A Hard Place, published 21 March 2022 by our US Investment Strategy, which is led by Doug Peta, a UChicago alum. 3    For insight into how central banks assess inflation and inflation expectations vis-à-vis commodity markets, particularly oil, please see the ECB's September 2020 working paper entitled " Global financial markets and oil price shocks in real time," by Fabrizio Venditti, Giovanni Veronese.  In it, the authors note, "The role that the price of oil plays in economic analysis in central banks and in financial markets has evolved over time. Oil is not seen anymore just as a (sic) input to production but also as a barometer of global economic activity as well as a financial asset."   4    The BIS recently noted augmenting standard Phillips Curve models with information from commodities and FX markets to reflect the profound changes wrought by globalization is critical for improving inflation forecasts, and explaining the dynamics of inflation and inflation expectations. Please see "Has globalization changed the inflation process?" by Kristin J. Forbes, published by the Bank for International Settlements in June 2019.  She notes, "The results in this paper suggest it is necessary to incorporate additional “global” factors in models of inflation dynamics, including global slack, non-fuel commodity prices (as well as oil prices), the exchange rate, and global price competition" to accurately explain and forecast inflation.  See below for further discussion. 5    In our modeling, the regressor with the best fit in our 5y5y CPI swap forecasts is the WTI 3-years forward futures contract. Both the 5y5y CPI swap rate and the WTI futures are non-stationary variables sharing a common long-term trend, meaning these are cointegrated random variables. The time series we use start in 2010, so post-GFC, which was a regime change for markets globally. The regression diagnostics are very strong, particularly for the ARDL model. We also find the 3-years forward WTI price is cointegrated with the prompt WTI futures contract, indicating these variables – one calling for delivery of crude oil in 3 years, the other in one month – are cointegrated. We get similar cointegration results using commodity indexes – e.g., the Bloomberg Commodity Index, and the LME base metals index – which tend to use futures contracts closer to delivery. This indicates commodity prices generally can be thought of as non-stationary variables vibrating randomly around a common long-term trend. We use cointegration models to avoid spurious relationships – e.g., regressing a stationary variable on a non-stationary variable. Statistically, cointegration is much stronger than simple correlation because it avoids the trap of spurious relationships. Please see Granger, C.W.J., Developments in the Study of Cointegrated Variables, Chapter 4 in Engle and Granger (eds): 1991, Long-Run Economic Relationships. Readings in Cointegration, Oxford University Press. This is an a article by Clive Granger, who received the Nobel prize in economics in 2003 for his pioneering work developing the mathematics of cointegration. See also Geman, H. (2007), Mean reversion versus random walk in oil and natural gas prices, in Advances in Mathematical Finance (pp. 219-228), for a rigorous discussion of random-walking oil and gas variables. 6    Please see Global Dimensions of U.S. Monetary Policy by Maurice Obstfeld, which appeared in the February 2020 issue of International Journal of Central Banking for an excellent discussion of the Fed's role in global trade. This is not all a one-way street, as Obstfeld notes, in that policy decisions can create "potential spillback onto the U.S. economy from the disproportionate influence of U.S. monetary policy on the outside world." 7     These cointegrating features of commodity markets, inflation rates and USD effects are not agreed by all economists. See, e.g., the Oxford Institute for Energy Studies report of August 2021 Is the Oil Price-Inflation Relationship Transitory? by Ilia Bouchouev. The paper notes, "In theory, the fundamental relationship that exists between short-term inflation and gasoline futures should be fading away with time, and for 5y5y breakeven it should indeed be close to zero. In practice, however, it is not." 8    Please see Forecasting the price of oil, which was published by the ECB in Issue 4 of its 2015. The Bank notes, "Oil price futures are frequently used as the baseline for oil price assumptions in economic projections. They are used, for example, in the Eurosystem/ECB staff macroeconomic projections and in the projections of many other central banks and international institutions. The main reason for using futures as a baseline for oil price assumptions is that they provide a simple and transparent method which is easy to communicate." (p. 90) 9    Please see Kogan, Leonid, Dmitry Livdan and Amir Yaron (2009), " Oil Futures Prices in a Production Economy With Investment Constraints," The Journal of Finance, 64:3, pp. 1345-1375.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

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

Highlights Industrial commodity and ag markets will continue to pull widely followed inflation gauges higher, as global fuel and fertilizer prices remain well bid (Chart of the Week). Unplanned production outages in Libya, faltering supply growth within OPEC 2.0 and a bullish read-through on demand in the wake of relatively mild public-health effects due to the omicron variant will keep oil prices well supported over the short term. Base metals prices will be pulled higher by the ongoing energy crises in Europe and China, which are forcing refiners to shutter capacity as fuels are re-directed to human needs. This is compounded by lockdowns in China – home to ~ 50% of global refining capacity – due to its zero-tolerance COVID-19 policy. These energy crises also are pulling grains higher, as farmers deal with soaring fertilizer costs – driven by soaring natgas prices – this year. Longer term – 2024 and beyond – industrial-commodity production will be concentrated in the hands of a few large producers. More explicit carbon pricing and ESG-induced cost increases will have to be recovered in higher wholesale prices for oil and metals. Grains will remain subject to volatile input costs, and erratic weather. We continue to favor broad-based exposure to commodities vis the S&P GSCI and the COMT ETF. Feature Fundamental supply-demand conditions in commodity markets – largely out of the control of fiscal- and monetary-policymakers – will continue to pull inflation gauges higher this year and for the rest of the 2020s. Oil markets are tight and getting tighter, owing to a dearth of capex since the price collapse triggered by OPEC's market-share war in 2014 (Chart 2). The same is true for base metals, where capex also has languished.1 Chart of the WeekCommodities Continue To Contribute To Global Inflationary Pressures Ag markets are confronting massive cost increases brought about by natgas shortages that first surfaced in 2021 and will continue to dog European and Asian fertilizer markets this year (Chart 3). These tight conditions leave markets vulnerable to unexpected supply and demand shocks, no matter how short-lived they might be. This is easily seen in oil markets: A force majeure declaration by Libya's national oil company following unplanned production shutdowns and pipeline maintenance pulled output below 800k b/d, or 30% lower than November 2021 levels, and almost completely neutralized a supply increase agreed by OPEC 2.0 earlier this week. Combined with what appears to be a relatively sanguine read-through on the impact of surging omicron infections in major consuming markets, these developments took prompt Brent back above $80/bbl.2 Chart 3Tight Natgas Markets Drive Fertilizer/Grain Prices Higher Oil Price Strength Will Persist Longer term – 2024 and beyond – OPEC 2.0's capacity to increase oil supply will be concentrated in the hands of a few large producers, while US shale-oil producers will face tougher ESG hurdles, which will raise their costs. More explicit carbon pricing also will raise costs. These cost increases will have to be recovered in higher prices. OPEC 2.0’s raison d'être at its inception in 2016 was to regain control over the level of global oil inventories. It has been remarkably successful in this endeavour, despite massive geopolitical uncertainty and a global pandemic (Chart 4). We do not expect any course changes over the coming years. What will change, however, are the fortunes of states in this coalition capable of increasing supply as global demand increases. At present, the Kingdom of Saudi Arabia (KSA) and Russia are the putative leaders of OPEC 2.0, and are two of the five states that can increase production at present (Iraq, the UAE and Kuwait also are in that group). By the end of this decade, the leadership of the coalition could come down to KSA and the UAE. While not certain, the US EIA expects Russia's output to level off and then gradually decline over the course of this decade. (Chart 5).3 Russia will remain a significant producer in the coalition, but it likely will be managing declining output as opposed to fighting for higher market share. Chart 4OPEC 2.0s Strategy Works Producers outside the OPEC 2.0 coalition – i.e., the price-taking cohort – have gone to great lengths to improve the attractiveness of their equity, and to maintain access to debt markets to fund their growth. These goals will not support any effort to increase production at the risk of reducing ROEs, as this would set efforts to regain investors' and lenders' favor back years. Going forward, capital markets, climate activists in board rooms and courtrooms, and an increasing load of ESG-related measures – most not yet even defined – will become central to the price-taking cohort's operations and returns. These will impose additional costs on the production of hydrocarbons, with explicit carbon pricing only one of many costs that will have to be recovered in higher prices. Base Metals Again Hit By Gas Shortages Shortages of natural gas continue to plague Europe: According to Gazprom, the Russian state-owned gas company, the continent has withdrawn more than 45% of total gas injected into storage this year, with peak winter in the Northern Hemisphere still to come.4 Just over 20% of power generation in Europe is gas-fired, which means tight gas markets drive gas prices and power prices higher. This power crunch is hitting the continent’s supply of refined aluminum and zinc particularly hard, which means global supplies also are being hit hard. Europe is responsible for ~ 12.5% and ~ 18% of global primary aluminum and zinc slab production, respectively. Low inventories at the start of winter, and cold weather is forcing European natgas to be directed to human needs at the expense of power generation. This has resulted in shutdowns of aluminum smelters in Europe – e.g., Aluminium Dunkerque Industries France was forced to curb production in the second half of December. Around the same time, Trafigura’s Nyrstar – which has the capacity to produce ~ 5.2% of global refined zinc – also announced plans to shut its zinc operations in France beginning January, citing high power prices. While power rationing has helped stabilize an earlier crisis in the world’s largest refined copper, aluminum, and zinc producer, the odds China’s power crisis will worsen has increased, following Indonesia's coal export ban in January to preserve the fuel for domestic energy security. China’s plans to curb air pollution ahead of the Winter Olympics next month will also dampen refining activity. Base metals also are contending with a new fundamental supply risk: Political uncertainty in the critically important producing states of Chile and Peru, the world’s largest producers of the red metal. Gabriel Boric, the new Chilean president, supports higher taxes on copper mining firms, as does his Peruvian counterpart Pedro Castillo. Boric’s election also signals more scrutiny on ore miners’ environmental practices – putting additional ESG-induced costs into wholesale copper prices. The uncertainty surrounding Peru’s constitutional rewrite, with the possibility for a change in mining rules to favor wealth redistribution and the environment will deter mining investments, according to Diego Hernandez, head of Sonami, the Chilean mining society. In Peru, the motion to and failure to impeach Castillo last month will increase political uncertainty, potentially reducing investors’ faith in the country’s mining sector. All of this has a chilling effect on investment in markets that are starved for capex.5 The lack of stable supply and low inventories have caused major price surges over the last year for industrial metals (Chart 6). We expect prices to rise and maintain higher levels over the course of this decade. Base metals production likely will fall short of demand as the world undertakes the green energy transition. Chart 6Copper Inventories Drawing Hard Investment Implications Industrial commodity markets are tightening over the short term and are on course to tighten further as the current decade progresses. This will raise the cost of the energy transition, as higher prices will be required to spur new supply investments in base metals, which are the sine qua non for this transition. This also will spur additional investment in oil and natgas supply, since these already have the infrastructure in place to move supply to market in order to meet the rising demand for energy we expect going forward. We will be exploring these themes throughout the year, particularly the implications for policy around the development of carbon-capture technologies – especially in natgas markets – and nuclear power, both of which may be the most "shovel ready" sources of incremental energy supply this decade.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish European natgas prices are once again rallying as inventories continue to be drawn down hard due to cold weather, reduced gas supplies from Russia, and higher demand generally (Chart 7). By the end of 2021, European natgas inventories were 57% full, vs the seasonal norm of 72%. At the end of December, close to 50 LNG tankers from the US were sailing to European destinations. As 2022 opens, the European TTF price for natural gas rose 30% to €94/MWh off their recent lows. Cargoes now will be bid in Asia, particularly in China, due to a halt in coal exports during January from Indonesia announced by the government at year end. China had replaced Australian coal imports with Indonesian-sourced material last year. Base Metals: Bullish MMG Ltd’s Las Bambas mine in Apurímac, Peru will restart operations after suspending production in late December. The mine's owner enacted the suspension following a month-long blockade at one of its key roads by the Chumbivilcas community. Prime Minister, Mirtha Vasquez travelled to the region to ensure the conflicting parties reached an agreement.  Las Bambas mine makes up ~2% of global mined copper supply and its tax payments are a significant source of government revenue. While an agreement was reached to lift the blockade, it did not address the Chumbivilcas’ primary concerns. The community wants the mine to employ more locals and provide higher cash contributions to support local infrastructure. This elevates the likelihood of further blockades and supply disruptions this year. Since it commenced operations in 2016, the Las Bambas mine has dealt with blockades over key roads on and off for over 400 days.  Ags/Softs:Neutral Global fertilizer markets will remain tight as natgas prices resume their rally and drive input costs higher. This will contribute to rising food price inflation and may result in global food shortages in 2022. High fertilizer prices might encourage farmers to delay planting this year, in the hope prices will fall. This risks increasing price volatility if too many farmers wait too long to apply fertilizers for their spring crops. Footnotes 1     Please see our most recent update on these factors in 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. It is available at ces.bcaresearch.com. 2     Please see Libyan crude output falls below 800,000 b/d published by argusmedia.com on January 4, 2022, and Oil futures: Prices steady after OPEC+ hike, Brent close to $80/b published by qcintel.com on January 5, 2022. 3    In its December 2021 assessment of Russia's oil-production potential, the US EIA noted: "… declining output from Russia’s more mature fields (primarily in Western Siberia, Russia’s largest oil producing region) may offset the production growth coming from greenfield development, which may result in Russia’s crude oil production declining by the end of the 2020s decade. In addition to greenfield development, companies are increasing drilling at some existing mature oil fields and are tying in smaller fields to existing infrastructure at larger fields to help increase recovery rates and mitigate some of the production decline. However, brownfield development efforts in Russia are unlikely to reverse the decline in production in the longer term." Please see Country Analysis Executive Summary: Russia, published by the EIA on December 13, 2021. 4    Please refer to Hoping for cheaper gas to come, Europe reverses Russian link to tap storage, published by Reuters on December 30, 2021. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021 for additional discussion   Investment Views and Themes Strategic Recommendations Trades Closed in 2021

We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation 

Dear Client, This week we present our annual Commodities & Energy Strategy outlook, which contains our key views on the principal markets we cover – energy, base metals and bulks, precious metals, and ags.  Over the coming decade, we expect industrial commodity prices to move higher in an increasingly volatile fashion, not unlike these markets' recent experience.  In the short term, commodity markets will remain exquisitely sensitive to the evolution of the COVID-19 pandemic.  The highly transmissible omicron variant of the coronavirus – now spreading at more than 4x the rate of the delta variant – appears to be less lethal than previous mutations, suggesting it could become the dominant variant globally.  We remain wary, however, particularly as China still is operating under a zero-tolerance COVID-19 policy, and has relied on less efficacious vaccines that appear to offer no protection against the omicron variant of the coronavirus.  This also is a risk for EM economies that rely on these vaccines.  However, the roll-out of mRNA vaccines globally via joint ventures will be gathering steam in 2H22, which is bullish for commodity demand. Longer term, the effort to decarbonize global energy markets is gaining traction, with the three largest economies in the world – the US, China and EU – embarked on a massive transition to renewables.  This will be a multi-decade undertaking that literally could transform the world.  We expect this to continue to unfold in an erratic and uncoordinated fashion, as states work out how to decarbonize the production, delivery and consumption of goods and services.  Markets critical to this transition, particularly base metals, face long odds developing the supply that will be necessary for this effort.  Conventional energy markets – oil, gas and coal – are in a forced wind-down imposed by courts, investors, governments, climate activists, public opinion and policymakers, which is reducing supply at a faster rate than demand.  This leaves markets exposed to volatile price bursts.  As is our custom, this will be the last CES report of the year.  This decade promises to be extraordinary for commodities, and we are hopeful we will continue to be of service in navigating the epic transition to a low-carbon future.  As you gather with friends and loved ones, we wish you all the best in this beautiful season, Robert Ryan Chief Commodity & Energy Strategist Highlights Macro: Bullish. Systematically important central banks will remain wary of moving too strongly too soon, in the wake of the COVID-19 omicron variant. US real rates will remain low and the USD will weaken, which will support commodities. Energy: Bullish. OPEC 2.0 and the price-taking cohort will maintain existing production policies, which will restrain oil supply. The omicron variant likely will dent demand, not tank it. Our 2022 Brent forecast is slightly weaker on omicron risk, averaging $78.50/bbl, with most of the demand hit in 1H22 made up in 2H22, while our 2023 forecast is $80/bbl. Base Metals: Bullish. Supply-demand balances will remain tight. Climate activism in courts and boardrooms; ESG-related costs, local and geopolitical uncertainty will continue to weigh on supply. COMEX copper will average $4.80/lb next year and $6.00/lb in 2023. Precious Metals: Bullish. Rising commodity prices will feed directly into inflation gauges favored by the Fed. Inflation and inflation expectations will remain elevated. Gold will push to $2,000/oz and silver to $30/oz in 2022. Ags/Softs: Neutral. Ag markets will remain balanced, with a bias to the upside from higher costs of fertilizer and transportation. Erratic weather remains an upside risk. Risk: Elevated. On the upside, a less lethal omicron variant that dominates other COVID-19 variants will rally markets. A more virulent mutant would hit demand harder and push prices lower. Hospitalizations/Cases and Deaths/Cases remain the critical ratios – trajectories need to remain flat to downward for growth (Chart of the Week). Recommendations: Our COMT ETF position was stopped out on 13 December 2021, which is when the ETF went ex-dividend. The ETF paid $5.4941/share for an 18.44% dividend (p.a.). Our stop-loss is being overridden, and we remain long the COMT ETF, in the expectation commodity markets will remain tight and backwardation will continue to drive returns. Feature COVID-19 continues to determine the trajectory of global growth – hence commodity demand – and how it will be distributed in the short run. Reports this week indicating the widely used Sinovac COVID-19 vaccine used in China and EM states is ineffective in neutralizing the omicron variant will renew the focus on an underappreciated risk: High vaccination rates in and of themselves are not useful indicators of successful public-health responses.1 More than anything, what appears to matter most is the vaccine that's been used to address the public-health threat posed by COVID-19. A booster of the Pfizer-BioNTech mRNA vaccine, e.g., appears to neutralize the omicron variant, and to convey a higher likelihood of avoiding serious illness and hospitalization.2 This will be important going forward, as the COVID-19 omicron variant appears to be transmitted at a rate that is 4.2x as contagious as the delta variant. This raises the odds that hospital beds will fill faster as the omicron mutant spreads.3 This could again lead to reduced availability of health care, and additional lockdowns to contain the spread of the omicron variant, which would again radiate through global supply chains. Oil Market Outlook Hinges On Omicron Response The risk exposed in these public-health developments is the global commodity recovery – particularly for crude oil and refined products like gasoline and jet fuel – could become more bifurcated this year, with economies using primarily mRNA technology continuing to open and recover. States without access to or distribution of these vaccines will have to rely more on social distancing and lockdowns to contain the spread of the virus. We would expect this to be a powerful inducement to accelerate local production and distribution of mRNA vaccines in Asia, Latin America and Europe. Successful implementation of this strategy would boost commodity demand, particularly for transportation fuels.4 Our prior regarding the omicron variant is it will dent demand but not tank oil demand. To account for the so-far-unknown effects of omicron, we are assuming 1H22 global crude and refined-product demand falls to 100.4mm b/d, versus our earlier estimate of 101.5mm b/d. Most of this demand is recovered in 2H22, when we expect oil consumption to average 101.8mm b/d versus our earlier expectation of 102.5mm b/d. On the supply side, OPEC 2.0 core producers – KSA, Russia, Iraq, UAE and Kuwait – will continue to implement the coalition's production-management strategy – i.e., keeping the level of supply just below demand. Meanwhile, the price-taking cohort led by the US shale-oil producers will continue to focus on profitability, not production for the sake of production. Accelerating production too rapidly at this point would undo much of the work and effort undertaken to establish oil and gas companies as attractive alternatives for investors. Our 2022 Brent forecast is weaker by $1.50/bbl vs last month's estimate, averaging $78.50/bbl. Our 2023 forecast is $1/bbl lower, with our average expectation at $80.00/bbl (Chart 2). Longer term, oil + gas capex remains weak (Chart 3). As we have stressed repeatedly, this is wicked bullish for prices in 2024 and beyond. Chart 2Brent Forecast Slightly Weaker In 2022 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Weak Capex Keeps Base Metals Outlook Bullish Weak capex is a common theme in the industrial commodities – oil and base metals – which points to tight supply-demand balances for these markets going forward. This is as true for base metals as it is for oil (Chart 4). The principal drivers of the capex squeeze are similar in both markets: A desire to regain investors' favor after years of poor returns. This has managements focused on returning capital to shareholders either in the form of share buybacks or higher dividend payments. However, there are additional pressures adding to the cost structures of industrial commodities, particularly the seismic shifts in the political underpinnings of commodity-exporting countries, where left-of-center politicians are proving more attractive to the median voter in states with contestable elections. Once elected – e.g., in Peru, and, likely Chile after this weekend's elections – politicians push hard to secure a greater share of mining revenues for long-neglected poor and indigenous populations.5 The bellwether base metal market – copper – best highlights these factors, which, in our view, will keep base-metals capex tentative and restrained over the medium term. Miners are almost forced to exercise capex restraint until they get greater clarity on how newly elected governments will deliver on their avowed intent to secure a greater share of mining revenues for their constituents. This is particularly true in Chile and Peru – which together account for a combined 40% of global copper ore output – where poor and indigenous populations are engaging in more frequent civil disobedience.6 In addition to the contentious changing of the guard at the political level, ESG-related initiatives brought to the fore by climate activists elected to corporate boards and in court proceedings are adding new layers of cost to base-metals mining (and oil and gas exploration for that matter). This week, Reuters reported on separate court decisions in Australia and Chile that redress mistreatment of aboriginal peoples in key metals-exporting states.7 We believe political and ESG-related costs will raise miners' all-in sustaining costs, which will have to be covered by higher prices going forward. The additional costs that will be imposed on miners trying to meet the demand that will be driven by the global decarbonization and renewable-energy buildout now kicking into high gear will require prices to spur investment in new mine production, and to keep existing and brownfield production up and running.8 Copper prices will get an assist from a weaker USD, which will boost demand for the metal ex-US (Chart 5). We are expecting copper to push to $4.80/lb on average next year and $6.00/lb in 2023 on the COMEX, on the back of stronger supply fundamentals and a weaker USD. Chart 5A Weaker USD Will Boost Copper Gold Will Rally As Inflation, Uncertainty Remain Elevated Gold prices will move higher in 2022 – our target remains $2,000/oz – as investors seek cover from higher commodity prices, which will feed directly through to higher inflation (Chart 6).9 This has been apparent in the recent US PCEPI and core PCEPI – the Fed's preferred inflation gauge – and CPI data, and at the wholesale level in PPI data. Most of this results from tight supplies for commodities and strong demand for goods, which is driving the price increases. We expect this to continue into 2022, as pent-up consumer demand continues to drive goods purchases and supply-side tightness for most manufacturing inputs. Higher prices across commodity markets will keep inflation gauges elevated in 2022. In addition to the inflation-hedging demand we expect next year, investors also will turn to gold as a hedge against economic policy uncertainty: As inflation and policy uncertainty increase, gold prices move higher (Chart 7). Chart 6Higher Commodity Prices Will Pressure Inflation Higher Chart 7Investors Will Use Gold To Hedge Inflation, Uncertainty   Lastly, in line with our colleagues in BCA's Foreign Exchange Strategy service, we remain USD bears in 2022. As is the case with all commodities, gold will benefit from a weaker USD.10 Ags Remain Balanced In 2022 Global ag markets, by and large, will remain balanced over the current crop year (Chart 8), with a bias to the upside as input and transportation costs – chiefly fertilizers and grain vessels, respectively – remain high (Charts 9 and 10). Erratic weather, as always, remains an upside risk. Chart 10… And Fertilizer Costs Will Push Grains, Beans Higher While we remain neutral grains, the periodic price spikes resulting from higher freight rates and natural gas prices will support overall commodity exposures. Over the short term, the risk of higher prices is acute: Markets still are contending with the possibility of another colder-than-normal winter. This would push natgas prices – and, because it is 70% natgas, fertilizer costs – sharply higher next year. This will have to be recouped by higher food prices, particularly if shipping costs spike higher due to COVID-19-induced port closures. Surging food prices will keep inflation rates higher globally, making them more persistent (vs. transitory). Investment Implications Global supply-demand fundamentals continue to support our conviction commodity markets will remain tight in 2022. As such we remain long commodity index exposure – the S&P GSCI and COMT ETF – expecting market tightness to result in renewed backwardation. We also remain long the PICK expecting continued tightness in base metals. Risks to our views remain elevated – and occur in both directions. On the upside, commodities will rally if a less-lethal omicron variant becomes the dominant COVID-19 strain and does not overly tax hospital resources or drive death rates higher. It could actually convey a global benefit as the dominant strain, crowding out other mutations and pushing states to herd immunity. On the downside, it's still too early to tell how this new variant and other mutations will behave. Given the fragility of the current global recovery and reopening shown in the initial response to omicron, a more virulent mutant likely would hit aggregate demand hard, forcing yet another supply-side adjustment in commodities generally. Upside risks dominate in our assessment, but, as always, we remain cautious.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Footnotes 1     Please see Sinovac shot offers inadequate shield from Omicron variant, says HK study published by straitstimes.com on December 15, 2021. The Sinovac vaccine is almost half as effective as mRNA-based vaccines, and is widely distributed in EM economies. We flagged this risk earlier in July in our report titled Assessing Risks To Our Commodity Views; it is available at ces.bcaresearch.com. 2     Please see Pfizer Booster Shots Are Effective Against Omicron Variant, Israeli Study Says published by wsj.com on December 12, 2021. 3    Please see Omicron four times more transmissible than Delta in Japan study published by straitstimes.com on December 9, 2021. 4    Please see Upside Price Risk Rises For Crude, which we published on September 16, 2021, for addition discussion of the global joint-ventures engaged in local production of mRNA vaccines. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021 and Chile: Prepare For A Boric Win, published by BCA's Emerging Markets Strategy service on December 15, 2021. The latter report discusses the growing odds of a victory for the left-of-center candidate in Chile's election this weekend. 6    Please see, e.g., Peru's poor Andean hamlets, backed by state, unleash anger at mines, published by reuters.com on December 14, 2021. 7     Please see Australian mining state passes Aboriginal heritage protection law, and Chile's Supreme Court orders new evaluation of Norte Abierto mining project published by reuters.com on December 15 and 14, 2021, respectively. 8    Incremental investment needed to meet 2050 net-zero climate goals will come to almost $2 trillion per year, half of which will go into renewable power generation, industrial processes, and transportation, according to estimates by Goldman Sachs, published on December 13, 2021. 9    Please see More Commodity-Led Inflation On The Way, which we published on December 9, 2021. It is worthwhile reiterating Granger-causality between realized and expected inflation gauges (US PCEPI, core PCEPI, CPI, along with 5-year/5-year CPI swap rates) and commodity price indices (the S&P GSCI and Bloomberg Commodity Index) is very strong. 10   Please see 2022 Key Views: Tug Of War, published by BCA's Foreign Exchange Strategy service on December 10, 2021.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021