Money/Credit/Debt

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversations, which we held remotely for a second year in a row due to the COVID-19 pandemic.   Mr. X: It is typically the case that I look forward to our end of year conversations, as they always help clarify the investment landscape for my daughter and I. This year, the feeling of excitement has unusually given way to a sense of foreboding. As far as the pandemic is concerned, clearly this year was a better one than last year, and I am encouraged by the progress that has been made around the world at protecting people from COVID-19 – although I do have some questions about the recent discovery of the Omicron variant. Risky assets have generally performed well year-to-date, and our portfolio has benefitted from that. But the longer-term investment outlook has certainly deteriorated: equity market multiples remain extremely elevated, government debt loads are still extraordinarily high, and now we have finally seen a surge in inflation – which, as you know, I have been concerned about for several years. I feel strongly that investors are unprepared for the eventual policy consequences of what has happened this year. Financial markets have been underpinned by easy money for too long, and if interest rates have to rise on a structural basis to control inflation, the financial market consequences will be severe – let alone the potential political and social consequences! I have steeled myself for a depressing conversation. Ms. X: As you may have sensed during our discussions over the past few years, I tend to have a more optimistic outlook than my father does. At a minimum, I believe that there are always investment opportunities that one can pursue, regardless of whether the macro regime is bullish or bearish for economic activity and risky asset prices. But I do have to say that the extent of the rise in consumer prices this year has unnerved me and made me marginally more inclined to agree with my father’s pessimistic long-term outlook. It is very unsettling to see headline inflation in the US at its highest level in three decades, and I very much hope that you will be able to provide some perspective about whether elevated inflation is here to stay. But before we get into our discussion of the outlook, perhaps we can briefly review your predictions from last year? BCA: Certainly. A year ago, our key conclusions were the following: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS. Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. Most of our investment recommendations panned out quite well this year (Table 1). Global stocks significantly outperformed long-maturity government bonds, advanced economies grew meaningfully above trend, monetary policy remained extremely easy, long-maturity bond yields rose moderately, and our call to favor cyclical sectors was a profitable one. Our bullish oil call worked out especially well, with Brent prices having risen roughly 60% from the beginning of the calendar year until the discovery of the Omicron variant. It remains 43% above its late-2020 level. Table 12021 Asset Market Returns A few calls did not perform in line with our expectations, however. We favored value versus growth stocks this year, and this call did work out in the first half of 2021. However, growth rallied in the back half of the year, in response to a renewed decline in long-maturity bond yields that was catalyzed by the emergence of the Delta variant. We would note that financials did outperform broadly-defined technology stocks this year (the two main representative sectors of the value and growth styles, respectively), underscoring that other factors impacted the overall value versus growth call. DM ex-US stocks underperformed this year, contrary to our expectations. When considering the euro area as a proxy for DM ex-US and when examining combined sector effects (both sector weight and performance) in local currency terms, almost all of the underperformance this year occurred due to the euro area’s comparatively low weight in the information technology and communication services sectors, underscoring that there has been a value vs. growth dimension to European equity underperformance. But when measured in common currency terms, the underperformance of DM ex-US stocks has mostly occurred due to the rise in the US dollar. The dollar was flat to down for the first half of the year, in line with our prediction, but rallied in the back half – especially over the past month, as new COVID cases surged in several European countries. Within the commodity space, our oil call worked out extremely well but gold fared poorly. This underscores that gold is far more sensitive to real interest rate dynamics than it is to the US dollar trend, which likely has bearish long-term implications for the yellow metal. We can address that later when we discuss the commodity outlook. Finally, we argued last year that we were experiencing a secular inflection point in inflation, but we did not anticipate the magnitude of the rise in consumer prices this year. As we will discuss in a moment, that reflects major pandemic-induced supply-side effects affecting consumer prices, which we believe will wane next year on average. That does not, however, mean that demand-side factors are irrelevant, and we do believe that core inflation will come in higher than the Fed currently expects in 2022. Peak Inflation – Or Just Getting Started? Ms. X: You mentioned the pandemic in your comments about supply-side inflation, and I feel that it would be a good idea to get your thoughts about COVID-19 up front. As my father noted, there has been enormous progress made this year towards ending the pandemic, but it is not yet over – as evidenced both by Europe’s recent 5th wave, as well as this highly concerning Omicron variant. I understand that you are not medical professionals, but what is your base case view of what is likely to happen next year? BCA: When we discussed last year’s outlook, it was certainly our hope that we would have declared a decisive victory in the war against COVID-19 by this point. That has not occurred, due to three major factors. Chart 1Vaccination Rates Are Too Low To Stop COVID From Circulating The first was the emergence of the Delta variant of COVID-19 in the middle of the year. Delta’s transmission and serious illness rate is higher than the original SARS-COV-2 virus and its Alpha variant, which rendered the goal of true herd immunity unachievable. The Delta variant of SARS-COV-2 has accounted for all new confirmed cases of COVID-19 around the world (until very recently), meaning that the bar for ending the pandemic has risen this year. Vaccine hesitancy and a slow approval process for vaccinating children is the second factor that has prolonged the end of the COVID-19 pandemic. While vaccine penetration has generally been high in most countries, a combination of hesitancy and the inability to vaccinate children under the age of 12 has left 1/4th to 1/3rd of the population of advanced economies unprotected against COVID-19. That might have been enough to prevent rising transmission of the original SARS-COV-2 virus, but it has proven to be too low to durably stop the ongoing spread of the Delta variant once disease control measures are relaxed or eliminated (Chart 1). In fact, as you noted, Chart 1 highlights that a 5th wave of the pandemic is in the process of occurring, especially within Europe. The vaccination of children has already begun in the United States and a few other countries, and many countries will likely follow suit in the weeks and months ahead. However, vaccination rates are likely to be lower among children given the considerably lower risk of severe illness, and it is clear that vaccine hesitancy among adults is sticky. The extent of vaccine hesitancy is most visible in the United States, where it has taken on a political dimension. Chart 2 highlights that US state vaccination rates are strongly predicted by the 2020 US Presidential election results, with states that voted for Donald Trump having on average a 12% lower vaccination rate than those that voted for Joe Biden. The third factor that has prolonged the pandemic, which seems to be linked to the emergence of the Omicron variant, is the fact that poorer parts of the world have not been able to make as much progress in vaccinating their populations, at least in part due to vaccine nationalism. We do not pass judgement on the governments of richer economies for prioritizing their own citizens, and indeed it would be hypocritical for us to do so as most of us at BCA have personally benefitted from that. But the consequence of those decisions is that some parts of the world, especially in Africa, have been left as de-facto breeding grounds for new variants. While the Omicron variant only came to light in the days leading up to the publication of this report, it does appear based on the available data that the variant emerged in Africa. Given all of this, we would be considerably more cautious in our outlook for the global economy next year if the progression of the pandemic were only dependent on the vaccination rate, especially now given the emergence of Omicron. However, two other factors will strongly influence the evolution of the pandemic and its impact on economic activity over the coming 12 months. First, in the US, states with a comparatively low vaccination rates likely have higher acquired immunity levels from previous infections, given that these states have recorded higher confirmed cases on a per capita basis. Chart 3The Delta Strain On US Hospitals Has Fallen, And Will Fall Further With Anti-Viral Drugs Second, and much more important, is the fact that anti-viral drug treatments with the ability to significantly reduce hospitalization and death have been discovered and are already under production. Molnupiravir, developed/produced by Merck and Ridgeback Biotherapeutics, has been shown to reduce the risk of hospitalization by 30%, and Merck is projecting that 10 million courses of treatment will be available by the end of December 2021, with at least 20 million courses to be produced next year. 1.7 million courses of treatments are set to be delivered to the US upon FDA approval, which compares with approximately 2 million COVID-related hospitalizations in the US over the past year. Chart 3 highlights that US ICU bed occupancy has already lessened, and the imminent deployment of effective drugs should lower ICU utilization even further over the winter months. Paxlovid, Pfizer’s oral anti-viral treatment for COVID-19, has been shown to be even more effective at reducing hospitalization, and news reports suggest the US government will order enough Paxlovid to treat 10 million Americans. Pfizer expects to produce roughly 50 million courses of treatment in 2022, and recently agreed to allow 95 developing countries to produce Paxlovid locally, suggesting that the impact of COVID-19 on the global medical system will be greatly reduced next year. This seems likely to be true even given the emergence of Omicron, as Paxlovid works by stopping the virus from replicating, by blocking an enzyme that does not appear to have mutated since the onset of the pandemic. Paxlovid does not target the spike protein, unlike monoclonal antibody treatments. Ms. X: The development of anti-viral treatments was seen as a very positive announcement because it had the strong potential to reduce or eliminate the impact of vaccine hesitancy on the medical system. But this new variant appears to be vaccine-resistant; doesn’t that mean that we might need far more of these drugs than we originally thought? BCA: Indeed. The fact that Omicron appears to be even more contagious than Delta and at least partially vaccine-resistant is legitimately concerning, because it could mean that many more courses of treatment of Molnupiravir and Paxlovid will be needed than will be available in the coming weeks and months to prevent a sharp rise in hospitalizations and deaths. At the same time, public comments by South African doctor Angelique Coetzee, who chairs the South African Medical Association and treated several patients suspected of having been infected with the Omicron variant, suggest that it may produce milder symptoms – which would be associated with a lower hospitalization rate.1 If Omicron outcompetes the Delta variant of the virus, but produces less severe disease, that could ironically prove to be a positive development. The fact that Omicron could render monoclonal antibody treatments useless could further reduce vaccine hesitancy in advanced economies and encourage the vaccination of children. That would further reduce the total incidence of severe illnesses even if Omicron is partially vaccine-resistant, and thus would be positive from the perspective of reducing the burden on the health care system. Still, South Africa’s population is considerably younger than those of advanced economies, and we will not know for some time whether a reduction in severe illness, if that proves to be true, applies also to those who are older. If Omicron threatens a significant hospitalization or fatality rate among the elderly who have been fully vaccinated, Omicron-specific booster shots for that age cohort will likely be required – which could take 3-4 months to become available. If that proves to be the path forward, the widespread reintroduction of “non-pharmaceutical interventions” (NPIs) – the policymaker codeword for travel bans, school closures, and lockdowns – is certainly a possible outcome in the first quarter. Omicron will have at least some impact on global travel over the coming month, as countries around the world decide to err on the side of caution and impose travel restrictions while more information is gathered about this new variant. To conclude on this question, as you noted, we are not medical experts. And frankly even if we were, we would not be able to project exactly how the pandemic will unfold next year. Thus, there is more uncertainty concerning our 2022 outlook than would normally be the case. Prior to the emergence of Omicron, our base case view was that the pandemic would meaningfully recede in importance next year, which would lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. For the reasons that we have laid out, we have not yet seen enough information to change that view for 2022 as a whole, although the opposite will likely be true for the next few weeks at a minimum. We may have to have you both back for another discussion in the first half of next year to revisit our outlook, but for now it is not our expectation that we are back to square one on the pandemic front. Chart 4A 30-Year High In US Inflation Mr. X: Thank you for your insights. Although this is clearly a concerning development, I suppose that there is no use panicking yet, as we do not have the information that we need to make an informed judgement. Perhaps we can turn to the question of inflation, given that seems likely to be an important economic and policy factor next year regardless of whether Omicron extends the duration of the pandemic. As both my daughter and I highlighted, this year’s rise in consumer prices was extreme, at least by the standard of the past three decades. As you know, I have my own views about why this has occurred, and I suspect that you do not fully agree with me. But for the sake of our discussion, please outline your views about what has occurred this year, and what that implies for policy and financial markets. BCA: As you noted, in both the US and euro area economies, headline consumer price inflation rose this year to their highest levels since the early-1990s (Chart 4). The rise in core inflation has been less extreme in the euro area, but it is also back to early-1990s levels in the US (panel 2). It is understandable that investors are worried about inflation remaining very elevated, and we agree that US inflation will likely be both above the Fed’s target as well as its forecast next year. However, our base case view is that investors are currently overestimating the magnitude of inflation over the coming 12 months, and that actual inflation will come in lower next year than what short-maturity inflation expectations are currently suggesting. As such, we do not expect that inflation next year will lead to a major shift in the monetary policy outlook, and we would continue to recommend that global investors stay overweight stocks versus bonds in 2022. Mr. X: I am surprised that you have a sanguine inflation outlook given how sharply consumer prices have risen this year. It sounds like you are blindly accepting the “transitory” narrative that central banks themselves are now questioning! This year’s surge in consumer prices has several causes, and a review of these factors is necessary to predict how future prices are likely to evolve. Fundamentally, any change in price can be traced to changes in supply and demand, and both of those effects worked in the direction of higher consumer prices this year. Chart 5 outlines the clear evidence of demand-side effects. The US fiscal response to the pandemic was more forceful than in the euro area, and US core consumer prices have correspondingly risen much more than in Europe. The chart highlights that US durable goods prices have been responsible for more of the surge in prices this year than has been the case for services, reflecting strong goods demand from US consumers. Chart 6 highlights that US real goods spending is 9.8% above its pre-pandemic trend, whereas it is 4.5% below for services. Extremely strong goods demand partially reflects the impact of fiscal and monetary stimulus, but also a shift in spending from services to goods owing to the nature of the pandemic and the type of activity that it has restricted. We expect that another shift in spending mix will occur next year in the opposite direction, barring a major extension of the pandemic from Omicron. Chart 5A Breakdown Of US Inflation Provides Clear Evidence For Demand-Pull Effects Chart 6US Goods Demand Is Well Above Trend You referenced the “transitory” debate in your question, and the answer to whether above-target inflation is likely to be transitory is both yes and no. Many of the supply-side effects that are driving prices are transitory, in the sense that they will not last beyond the pandemic. That view should not be controversial. But, some of the demand-side effects lifting prices are not. Chart 7A Shortage Of Service-Sector Workers Has Boosted Wages And Services Prices In the US, supply effects are seen by observing services prices. Services prices in the US have risen despite a collapse in demand, pointing to supply-side effects as the dominant driver of higher prices. A significant decline in labor force participation has caused a shortage of workers, which is driving up wages for the first quartile of wage earners (the lowest paid) who often work in service-providing industries (Chart 7). Faced with higher labor costs alongside low operating margins and the expectation that demand will continue to recover, service providers have raised prices to stay afloat. The specific causes of the ongoing labor market shortage in the US are multifaceted, but most relate directly to the pandemic: There has been a surge in the number of retirees, mainly driven by a sharp slowdown in the number of older Americans (who are more vulnerable to COVID-19) shifting from “retired” to “in the labor force”. Workers in some sectors of the economy that experienced a surge in demand during the pandemic (technology, health care, food products, transportation, and manufacturing) have experienced burnout and have quit their jobs. Some service-sector workers have complained of difficult working conditions during the pandemic (the need to wear masks, the policing of masks and vaccination passports, overwork due to short-staffed conditions, negative interactions with customers, etc.) and have instead chosen not to work until these conditions improve. Some parents have been unable or unwilling to reenter the labor force due to increased childcare requirements resulting from daycare/school/classroom closures. Chart 8Fewer Immigrants = Higher Wages Chart 8 highlights that legal immigration to the US collapsed during the pandemic following a restriction in worker visas last year, which has also likely exacerbated worker shortages in some industries. Illegal immigration has surged over the past year, but illegal workers do not necessarily immediately enter the labor market and are often employed in a narrow set of industries. Mr. X: But if these supply-side effects that you are pointing to are mostly on the services side, does that not imply that goods inflation will remain very elevated next year due to excessive demand? BCA: No. As we mentioned, some of this goods spending is being funded by income that would normally go towards services spending. We doubt that a services spending deficit will be sustained if the pandemic recedes next year, meaning that some spending will naturally be diverted away from goods. Chart 9Supply-Side Effects Have Significantly Boosted Global Shipping Costs In addition, other supply-side factors are also impacting consumer prices for both goods and services, and on both sides of the Atlantic: Global shipping costs have surged, particularly for cargo containers traveling from China / East Asia to the west coast of the US. US demand for goods has certainly boosted shipping prices, but Chart 9 highlights that supply-side effects have also been present. The large rise in China/US shipping costs since late-June appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Semiconductor shortages have limited automotive production, thereby significantly boosting US vehicle prices. These shortages have occurred, in part, due to a global surge in semiconductor demand stemming from work-from-home policies, but also demand/supply coordination failures last year (auto producers initially cut chip orders on the expectation of collapsing car sales) and COVID-driven plant shutdowns in some Asian countries such as Malaysia. Energy prices have risen this year, partially due to supply-side / policy decisions. In the case of oil & gasoline prices, OPEC’s production decisions clearly reflect a desire to maintain oil prices at roughly $80/bbl, 30% above the level that prevailed prior to the pandemic. US shale producers have focused on repairing their balance sheets over the past year, and have not been able to take advantage of higher prices to boost output. Chart 10 highlights that US tight oil production remains roughly 10% below its pre-pandemic peak. In Europe, the impact of higher energy prices has occurred mainly though a spike in the price of natural gas, mostly due to weather, carbon pricing, Russian supply issues, and a surge in China’s natural gas demand. Chinese natural gas demand has surged in response to very strong manufacturing activity / export demand, but also previous decisions by Beijing to shift towards cleaner energy sources and the limitation of coal imports from certain countries (which has contributed to a collapse in Chinese coal inventories). So while it is clear that there is a strong underlying demand component that has boosted goods prices, supply-side factors have magnified the acceleration in consumer prices this year. Most of these supply-side factors (except for oil) have been directly linked to the pandemic, and thus are likely to wane in 2022 if the pandemic recedes (as we currently expect). In the case of oil, our view is that spot prices in 2022 are likely to average the price that prevailed prior to the Omicron-driven collapse in prices, meaning that the energy component that has been boosting headline price indexes this year will likely disappear next year even if recent travel bans are not long lasting and oil prices fully recover. Ms. X: Even if the pandemic does recede in importance and household spending shifts from goods to services next year, you acknowledged that goods spending is also being boosted by policy. This implies that goods spending will remain above trend next year, and that it will continue to boost consumer prices. Doesn’t that argue for elevated inflation? BCA: We agree that several factors point to above-trend goods spending next year, and this is the basis – in addition to lingering supply-side effects – for our view that US inflation will likely be both above the Fed’s target as well as its forecast for 2022 (2.2% headline and 2.3% core). However, Chart 11 shows a historically unprecedented “goods spending gap” relative to the overall output gap. It is unlikely that this has occurred only due to stimulative policy. Services spending collapsed during the pandemic, as Chart 6 highlights. So while goods spending will likely remain above its trend, supported by policy as well as a large stock of excess savings, it is likely to decline next year. Chart 10US Shale Production Has Not Returned To Its Pre-Pandemic Level Chart 11US Goods Spending Is Much Too Strong To Be Explained By Policy Alone   Lower goods demand in advanced economies will not only ease rising goods prices. It will also help ease Europe’s energy crisis, as it implies less competition for natural gas from China’s power companies which are struggling to supply the manufacturing sector. Chart 12Short-Term Inflation Expectations Have Exploded; Long-Term Expectations Are Contained Ms. X: One thing that has concerned me is how significantly inflation expectations have risen. Won’t persistent price increases become self-fulfilling if consumers and businesses come to expect inflation? BCA: This is a risk, and the dynamic that you are referring to is explicitly incorporated into modern-day interpretations of the Phillips Curve. However, if this were likely to occur, we should be able to observe a dangerous rise in both short- and long-dated inflation expectations on the part of investors, businesses, and households. Chart 12 highlights that long-term inflation expectations are not out of control. Short-term expectations for inflation have indeed exploded higher, but longer-term expectations remain under control. Inflationary pressure during the pandemic has normalized longer-term household expectations for inflation, which fell following the 2014/2015 collapse in oil prices. And long-dated market-based expectations for inflation have not even risen back to pre-2014 levels, underscoring that investors do not believe that current inflationary pressures are likely to persist. A breakout in long-dated inflation expectations next year would negatively alter our monetary policy and economic outlook, but it is clear that economic agents believe that current price pressure is directly linked to the pandemic. We agree, for the most part, and thus expect concerns about inflation to step down next year. Mr. X: Let’s turn to the question of extremely elevated government debt. We discussed this issue last year, and you noted that the explosion in public debt loads would carry significant future costs. Governments have been kicking the can down the road for a long time now, and I am interested in your perspective about the timing of the endgame. When do you think the day of reckoning will arrive? BCA: It is true that government debt-to-GDP ratios have risen substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. This has been truer in the US and UK than in the euro area, which has seen a comparatively smaller rise in government net debt as a % of GDP since the early 2000s (Chart 13). In the US, the government debt-to-GDP is now nearly as high as it was at the end of the Second World War. Chart 13 also highlights that the IMF is forecasting a reduction in government net debt as a share of GDP in the euro area over the coming 5 years, a modest rise in the UK, and larger rise in the US. Over a 30-year time horizon, the US government debt-to-GDP ratio is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years (Chart 14). Part of the CBO’s forecast of a catastrophic rise in government debt-to-GDP is due to projections of a persistent primary deficit that will grow over time. But it is also the case that the net interest component of the CBO’s projected deficit begins to rise significantly as a share of the total deficit at the start of the next decade. This rise in net interest payments occurs significantly because the CBO assumes that interest rates will eventually exceed the prevailing rate of economic growth due to crowding out effects (Chart 15). Chart 14The CBO's Long-Term Budget Outlook Is Dire... Chart 15...Partially Because Of The CBO's Interest Rate Assumptions   We doubt that this will occur, at least not in the linear fashion the CBO is projecting. It is true that central banks only control the short-end of the yield curve (absent yield curve control policies), meaning that investors could force yields on long-maturity government bond yields to rise above the prevailing level of nominal growth. But in a world of scarce absolute returns, it is unlikely that investors will price long-maturity US government bonds with an elevated term premium until the US government’s debt service burden becomes extreme. Given that a significant portion of the US government’s debt is issued with a short maturity, that debt service burden is at least partially a function of the Fed’s decisions, not those of bond investors. Chart 16US Taxes Are Low, Contributing To Its Primary Deficit An increase in real short-term interest rates over the coming several years might, ironically, be the best thing for US government debt sustainability over the long term, even though it would cause the US government’s debt service burden to rise. Ultimately, debt sustainability requires a balanced primary budget, and the structural US primary balance is heavily impacted by elevated medical costs and the fact that US government revenue as a share of GDP is considerably lower than in other countries (Chart 16). Given the political costs involved, primary balance reform in the US is unlikely to occur without some form of budgetary pressure from rising interest costs, and the longer the US government’s debt service burden remains low the longer that this reform is delayed. You asked about the timing of the endgame, and a potential tipping point may be when US government spending on net interest as a share of GDP exceeds the prior high reached in the early-1990s, which could occur as soon as 5 years from now were the Fed to raise interest rates towards the pace of nominal GDP growth.2Without such an increase, the US government’s debt burden will likely remain serviceable for decades, even without primary balance reform. Mr. X: I am happy that you referenced the Fed in your answer, because I wanted to address the question of central bank independence. Will elevated government debt prevent the Fed from raising rates if needed to control inflation? With the Fed projecting a very low Federal funds rate in the future, it seems like today’s central bankers may be incapable of acting as Volker did, should they need to do so. BCA: It is true that the Fed is projecting a very low average long-term Fed funds rate, but this projection is not due to political pressure or concerns about the US government’s future debt service burden. It reflects the Fed’s belief that the neutral rate of interest has fallen, based on the economic experience of the past decade, as well as the belief that an asymmetry exists in the economic costs of errors associated with estimating the neutral rate. On the latter point, the Fed believes that the cost of overestimating the neutral rate is likely to be higher than the cost of underestimating it, given the inability to cut interest rates meaningfully below zero. During our discussion last year, we noted that rising populism will make it very difficult for fiscal authorities to take preemptive action to address the US’s primary deficit, and it is possible that public opposition to normalized interest rates could cause the Fed to maintain easier monetary policy than is otherwise warranted – especially if the public perceives a link between Fed tightening and painful fiscal reform. However, our base case view remains that the Fed would resist these pressures, and would act in a way that the central bank felt was the best course of action to pursue its mandate. We would underscore that the risk of an overshoot in inflation from too-easy monetary policy does not require the Fed’s independence to become compromised. The Fed could be wrong in its assessment of the neutral rate of interest, and also wrong in its assessment of the costs of that error. Leaving the latter issue aside for now, there are good arguments in favor of the view that the neutral rate of interest is higher than the Fed currently believes. We can discuss those arguments in detail when we turn to the bond market outlook, but this does imply that inflation may be even more above the Fed’s target over the medium term than we believe will be the case next year. Ms. X: I have one last question related to inflation before we move on to your economic outlook. In terms of the usage of technology, the pandemic caused major behavioral changes to occur very quickly. Is it possible that we are on the cusp of a productivity boom, similar to what occurred during the 1990s, that will act to restrain inflation over the coming few years? BCA: It is possible that the pandemic has catalyzed some changes that will end up boosting productivity, given that many consumers, workers, and businesses were forced to embrace innovation quickly over the past 18 months. Governments have also made historic investments in both hard and soft infrastructure, including high-speed internet and renewable energy. But, for now, there is little evidence to support the idea that a major, technologically-driven productivity boom is occurring. Chart 17 highlights that measured productivity has fallen outside of the US since the pandemic began, and the US surge is likely explained by three factors: labor market composition effects, the fact that US productivity normally rises during recessions, and the fact that US fiscal response was more forceful than elsewhere (boosting spending and output relative to the number of workers). The cyclical characteristics of US measured productivity were particularly evident in Q3, when output per hour of all employees fell by roughly 5% on an annualized basis. It is also the case that the pandemic has likely lowered potential output in some areas of the economy, particularly sectors related to office worker presence in central business districts. Even if employer plans for workers to return to the office prevail and office presence increases significantly in 2022, it is very likely that some work-from-home activity will permanently stick and that this will structurally increase the US unemployment rate.3 For now, our sense is that this increase will be modest, but the key point is that the rapid adoption of new technology and ways of working during the pandemic have not occurred without cost, and it is far from clear that this will be productivity-enhancing on a net basis. The ongoing, typical pace of technological development may help ease inflationary pressures over the longer-term, but investors should not yet conclude that the pandemic has accelerated this process. The Economic Outlook Chart 18On Average, We Expect Above-Trend Growth In The DM World Next Year Ms. X: Thank you. I am not entirely sure that I am convinced, but I take your point that the productivity issue needs to be examined on a net basis. Let’s turn now to the outlook for growth next year. Starting first with developed markets, what do you expect in terms of the pace of economic growth, and how does that expectation differ from consensus market expectations? BCA: While we are less concerned about short-term inflation than most investors, we generally agree with consensus expectations for growth next year. Chart 18 shows that both official and private forecasts for real GDP growth in the US and euro area are well above trend, and that the US and euro area output gaps are likely to turn positive next year. In Q4 2021 and Q1 2022, it is possible that the Omicron variant will negatively impact economic growth. But assuming that the pandemic does recede in importance for the year as a whole, the basis for expecting above-trend growth in advanced economies next year is straightforward: we expect that monetary policy will remain extremely accommodative in the US and euro area, and will likely remain so even if the Fed begins to raise interest rates. In addition, the collapse in spending that occurred last year, arrayed against stable-to-higher income, has caused households to accumulate a massive amount of savings that will support consumption. Chart 19Households In The US And Europe Have Accumulated Excess Savings Chart 19 highlights that this has occurred in both the US and the euro area. In the euro area, income was relatively stable, and spending has yet to fully recover – supporting the view that a catch-up in European consumption will boost euro area growth to above-trend levels. In the US, personal income rose during the pandemic, because the US government issued stimulus checks to Americans who did not lose their job. Some of these excess savings have been spent or used to pay down debt, but a sizeable portion remains to support spending. Chart 20 highlights that US household net worth has exploded higher over the past 7 quarters, by a magnitude that far exceeds any other instance since the Second World War. It is true that fiscal policy will subtract from growth in both the US and euro area next year, although it remains an open question how much drag will occur in the US. Chart 21 presents the Hutchins Center Fiscal Impact Measure from the Brookings Institution, which suggests that US fiscal drag will be significant in 2022. This measure does not include the recent infrastructure bill, or the Build Back Better plan. However, Chart 22 presents the IMF’s projections for the US and euro area cyclically-adjusted budget balance, which suggest meaningfully less drag next year for the US. Chart 20US Household Net Worth Has Surged In the case of the euro area, Chart 22 highlights that the IMF is forecasting considerable fiscal drag next year, which seemingly contradicts optimistic expectations for euro area growth. There are two reasons to believe that euro area growth will be meaningfully above-trend in 2022, despite fiscal retrenchment. First, the IMF’s projected reduction in the euro area’s cyclically-adjusted primary deficit reflects the expiry of employment support programs such as the Kurzarbeit scheme in Germany, a social insurance program that incentivizes employers to reduce employee hours rather than laying off workers. The expiry of these types of programs is politically tied to a continued recovery in domestic consumption and further gains in service-sector employment, meaning that some of the fiscal drag projected in Chart 22 is necessarily linked to a growth impulse from the private sector. Certainly, these programs will be renewed or extended if the Omicron variant significantly weakens near-term economic growth in the euro area. Second, while the positive contribution to euro area growth from goods exports will likely wane over the coming year as spending in advanced economies shifts from goods to services, European services exports will eventually improve. Chart 23 highlights that the recovery in foreign tourist visits to the euro area is in its very early innings, and a normalization of tourist travel will eventually act as a significant contributor to income and employment growth in the region. According to the World Travel & Tourism Council, Europe was the third most impacted region globally from the decline in travel, after the Caribbean and Asia Pacific.4 It is clear that tourist travel will not pick up as long as Omicron-related travel bans are in effect, but Europe’s peak tourist season typically runs from June to August, which is beyond the range of time supposedly needed by vaccine manufacturers to produce Omicron-specific booster shots (should they be required). Chart 23European Tourism Will Eventually Recover, Adding To A Domestic Consumer Spending Tailwind Mr. X: I would like to challenge you on your growth view. First, the economy was already slowing, and now there is a risk that the Omicron variant might slow at least some economic activity even further in the near term. You have stated that there will be some degree of fiscal drag next year, and that savings might be deployed to support spending – but might not. Should I not be concerned that growth might fall back to trend or even below it? BCA: The pandemic was economically unprecedented, and investors should thus be careful about what growth rates are used to characterize the pace of ongoing economic activity. For example, Chart 24 highlights that euro area real GDP growth is slowing on a year-over-year basis, but it accelerated fractionally on a sequential basis in Q3 and grew substantially above-trend. It should not be surprising that advanced economies are no longer reporting double-digit growth rates given the ongoing recovery from extremely depressed rates of economic activity last year. The question is whether growth will slow dramatically further, and whether at or below trend growth is likely on average next year. Prior to the discovery of the Omicron variant, investors had little reason to be concerned about significantly below trend growth in 2022. Forward-looking economic indicators were not pointing to this outcome; Chart 25 shows our global Nowcast indicator, a high-frequency measure of economic activity that is designed to predict global industrial production, alongside our global leading economic indicator. The chart shows that both the Nowcast and global leading economic indicator (LEI) are indeed declining, but that this decline is occurring from an extremely elevated level. It is therefore correct to say that the global economy is at an inflection point in terms of the pace of growth, but Chart 25 still points to above-trend growth – and certainly not to a major cyclical downturn. Chart 24Growth In DM Economies Is Slowing, But Remains Above-Trend Chart 25Leading Indicators Continue To Point To Above-Trend Growth   The US economy did experience a very significant sequential slowdown in Q3, with activity having increased at only a trend rate. Chart 26 makes it clear that this occurred due to the impact of the semiconductor shortage on automotive production and the impact that the Delta wave of COVID-19 had on services spending. Real-time estimates for US growth in the fourth quarter are (for now) quite strong, and growth estimates for next year already likely incorporate the expectation of supply-side limitations. In fact, those expectations could surprise to the upside next year if these limitations ease more quickly than many investors currently expect, and if the Omicron variant turns out to be economically insignificant. If, however, the new variant does end up causing the return of lockdowns and other large-scale “NPIs” – especially in emerging market countries – the risk of further bottlenecks or an extension of existing supply-side problems will certainly rise. Ms. X: Could you provide us some scenarios that combine your growth and inflation views, as well as the odds that you would assign to them? BCA: Certainly. Chart 27 presents our odds of three scenarios for global growth and inflation next year. We assign a 60% chance to above-trend growth and above-target inflation, a 30% chance to a “stagflation-lite” scenario of growth at or below potential and inflation well above target, a 10% chance of a recession. We describe the second scenario as “stagflation-lite” because true stagflation, as experienced in the late-1970s, involved a very elevated unemployment rate. Using the US Misery Index as real-time stagflation indicator for advanced economies (Chart 28), investors should note that true stagflation is not likely unless the unemployment rate rises. Despite the ongoing impact of component and labor shortages, there is no evidence yet of a contraction in goods-producing or service-producing jobs. For now, the impact of outright component shortages appears to be limited to the auto sector. Chart 28It's Not True Stagflation Unless The Unemployment Rate Rises Even if goods-producing employment slows anew over the coming few months due to supply constraints, the unemployment rate is still likely to fall if services spending normalizes. This underscores the importance of services spending in advanced economies as a core driver of global economic activity over the coming year, given the ongoing weakness in several segments on China’s economy. Mr. X: My daughter and I have been closely watching China’s economy this year, and we have been getting increasingly concerned by the extent of the slowdown in activity there. Do you anticipate a pickup in Chinese growth in 2022? BCA: Yes, but a reacceleration in Chinese economic activity is more likely in the back half of next year than over the coming 6 months. There are three reasons for this. First, economic output in China will continue to be restrained over the coming months by the country’s ongoing energy crisis, which caused a sharp slowdown in electricity production in August (Chart 29). Production rebounded somewhat in September and October, but remained fairly weak. China’s energy crisis has occurred due to a combination of very strong electricity demand from the country’s manufacturing sector, as well as a significant reduction in coal emphasis, including coal imports from key producers that otherwise would have helped close the supply-demand gap (Chart 30). China’s coal stocks remain extremely low, underscoring that Chinese policymakers would not be capable of pushing through traditionally energy-intensive stimulus even if they were inclined to do so. Chart 29China's Energy Crisis Will Linger Second, strong external demand is supporting Chinese manufacturing employment (Chart 31), so Chinese policymakers feel less of a sense of urgency to boost economic growth despite a significant slowdown in China’s credit impulse and the ongoing slowdown in real-estate activity. Social stability will always remain the paramount objective of Chinese policymakers, and we fully expect a policy response if economic growth slows to the point that it impacts employment. Chart 30China's Energy Crisis: Strong Power Demand, Constrained Coal Supply Chart 31Strong External Demand Is Supporting Chinese Employment But because of the extreme rise in private-sector debt that has accumulated in China over the past decade, Chinese policymakers now perceive a tradeoff between economic growth and additional leveraging. This implies that the timing and magnitude of reflationary efforts from China’s policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth, in line with what occurred in 2018 and 2019. In fact, while many investors regard China’s policy response during that time as having been too timid, within China many commentators have lauded it as an example of finely balanced decision-making. Third, China’s zero-tolerance COVID policy will likely remain in effect at least until the Beijing Olympics in February, and potentially until the 20th National Party Congress in October. The potential risk from the Omicron variant will only reinforce the resolve of Chinese policymakers on this issue, which implies that Chinese consumption and services activity could follow a stop-and-go pattern over the coming 6 months. Chinese policymakers are likely aware that a zero-tolerance policy towards COVID is ultimately unsustainable, but we expect policymakers to react aggressively towards outbreaks next year in advance of these two major events. Ms. X: It sounds like Chinese policymakers do not want to stimulate at all. Why is a reacceleration in activity even likely? BCA: We expect further easing from Chinese policymakers next year because the strong demand for Chinese goods that is currently supporting employment is likely to slowly wane over the coming several months. Chinese export volume has been very closely tied to US real goods consumption over the past year (Chart 32), which, as we noted earlier, is 9.8% above the level implied by its pre-pandemic trend. A likely decline in US goods spending from current levels, even if it remains above trend, suggests that Chinese manufacturing employment will not be as strong on average next year as is currently the case. Chart 33 highlights the extent of the weakness in China’s credit impulse and its real estate sector, underscoring that China is currently a “one-legged” economy that is supported by manufacturing. Chart 32China's Exports And US Goods Spending Are Closely Linked Chart 33China's Economy Is Now Entirely Supported By External Demand     In addition, for political reasons, policymakers in China are very likely to want stable-to-improving economic conditions in the lead up to the National Party Congress in October. Given the lags between the implementation of stimulus and its effect on the economy, this points to further easing and/or outright stimulus in Q1 or Q2, and a reacceleration in economic activity in the latter half of the year. Chart 34Inflation Expectations, Not Real Rates, Have Been Driving The Bond Market Ms. X: Let’s turn now to monetary policy. You mentioned that monetary policy will remain very easy next year, but investors have moved to price between one and two interest rate hikes from the Federal Reserve in 2022. Do you agree with the market’s assessment? BCA: Our base case view is that investors are now overly hawkish and that an initial rate hike will most likely occur only in September or December 2022 – despite a seemingly hawkish pivot from the Fed. It is important to note that investors have moved up their expectations for rate hikes next year entirely in response to elevated inflation. Chart 34 highlights that the sharp increase in the US 2-year Treasury yield over the past few months has occurred alongside a decline in the real 2-year yield, underscoring that investors believe that inflation will force the Fed to raise interest rates earlier than it currently expects. We expect the pressure on prices to wane next year rather than intensify, meaning that rate-hike bets have likely been driven by the wrong factor. A dangerous rise in long-dated inflation expectations would change our view and validate market pricing. But, as we noted above, this has not yet occurred despite very elevated inflation this year and expectations of elevated inflation next year. This underscores that economic agents view the current pace of inflation as strongly linked to the pandemic, and thus see it as a temporary phenomenon. Table 2The Fed’s Liftoff Criteria Table 2 presents the three factors that will determine when the Fed decides to lift rates, based on the Fed’s official forward guidance. The two inflation-related criteria are currently checked, but the remaining labor market criterion is not checked. The Fed has officially pledged not to lift rates until “maximum employment” is reached, although that pledge may change in December. Still, we expect that progress towards “maximum employment” will influence the timing of the first rate hike unless there are no signs of easing inflation over the next several months. Our sense is that an unemployment rate close to 3.8% and a working-age participation rate close to its pre-pandemic level will be required to check the third box shown in Table 2. Chart 35The Working-Age Participation Rate Still Has Further To Rise Importantly, it is not clear that these factors will be in place before September next year. Chart 35 highlights that while the working-age participation rate has moved back closer to its pre-pandemic level, it still has further to go. If the rate increases at the pace that occurred in the first half of this year, it would not return to its pre-pandemic level until August/September at the earliest, which would certainly narrow the window for two rate hikes next year. The bar for the Fed’s unemployment rate criterion is also high enough that betting on two rate hikes next year appears excessive. Table 3 presents the average monthly jobs growth needed to reach an unemployment rate of 3.8% at different points over the next year. This highlights that a meaningful and sustained acceleration in jobs growth is required for the Fed to raise interest rates in July. Table 3Calculating The Time To Maximum Employment Mr. X: But these projections are based on the overall participation rate, and we have seen a surge in retirements during the pandemic. Doesn’t that mean that the unemployment rate will fall faster than the Fed currently expects, and that investors are right to move up their rate hike expectations? BCA: We have seen a huge increase in the number of retirees, and you are correct that a more rapid reduction in the unemployment rate could occur if pandemic retirements turn out to be “sticky”. However, we would point to two facts that suggest at least a portion of the surge in retirements will reverse. Chart 36Retirements Have Significantly Overshot Their Demographic Trend First, the surge in retirement during the pandemic is more than what would be implied by underlying demographic trends. Chart 36 shows that while the share of the US population that is retired has been steadily rising, it is now significantly above its 2010-2019 trend. Second, a recent study from the Kansas City Fed suggests that the non-demographic component of the recent surge in retirements has mainly been driven by a decline in the number of retirees rejoining the labor force,5 a phenomenon that we would expect to reverse as the pandemic abates. If the Omicron variant turns out to be threatening to the health of the older population even if they have been vaccinated, then we would not expect retiree reentry into the labor force until variant-specific booster shots are available. Chart 37Investors Expect The ECB To Lag The Fed, And We Agree Uncertainty over the status of retired workers is why we believe the Fed will focus on the working-age participation rate in judging whether the labor market has returned to a state of maximum employment. If the unemployment rate falls more quickly than expected because of a retiree-effect on the overall participation rate, the Fed will then turn to the working-age participation rate to judge the extent of labor market slack. It is only if non-supply driven wage growth is excessive and/or long-dated inflation expectations move sharply higher that the Fed will move in line with current market pricing. Mr. X: What about the ECB? Do you expect any monetary policy tightening in the euro area in 2022? BCA: Chart 37 highlights that investors had previously been expecting the ECB to raise interest rates once next year, lagging the Fed by roughly one rate hike. These expectations have been dialed back recently in response to the COVID situation in Europe as well as the news about Omicron. Chart 38Euro Area Inflation Is Not Broad-Based We agree that the ECB will raise rates after the Fed does, but we do not think that a euro area rate hike will occur next year – even once the pandemic situation improves. As is the case for the Fed, investors had been expecting that the ECB will be forced to respond to very elevated inflation. But Chart 38 highlights that euro area core inflation is barely above 2%, and panel 2 makes it clear that the rise in core euro area prices is not broad-based. This underscores that much of the rise in euro area prices is driven by commodities and problems with the global supply chain, neither of which will be fixed by higher euro area interest rates. As such, we agreed with ECB President Christine Lagarde’s pushback against market expectations for a rate hike next year, barring a much faster labor market recovery in advanced economies than we currently expect. Bond Market Prospects Mr. X: Thank you. Our monetary policy discussion serves as an excellent segue to the bond market outlook, and a question that I have been eager to pose to you. I find it astounding that long-maturity government bond yields remained so low this year given the longer-term inflationary risk, and given recent bets that central banks would be forced to move earlier than they had previously anticipated. Even if those bets unwind as a result of Omicron, I would like an explanation of what kept bond yields so low this year. In particular, I would like you to share your thoughts about what could cause bond yields to eventually react to the potential for higher inflation? Chart 39Investors, And The Fed, Continue To Subscribe To The Secular Stagnation Narrative BCA: The behavior of long-maturity government bonds this year reflects the view of both the Fed and market participants that the neutral rate of interest (“R-star”) remains very low relative to the potential growth rate of the economy (Chart 39). According to the Federal Reserve’s Statement on Longer Run Goals And Monetary Policy Strategy, the FOMC “judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average.” Bond investors agree with the Fed’s view, bolstered by previously low academic estimates of the neutral rate of interest such as those presented by the Laubach-Williams model. We agree that R-star fell in the US for a time following the Global Financial Crisis (GFC), but it is far from clear that it remains as low as the Fed and investors believe. The neutral rate of interest fell during the first half of the last economic cycle because of a persistent period of household deleveraging and balance-sheet repair, which was a multi-year consequence of the financial crisis and the insufficient fiscal response to the 2008-09 recession. Academic estimates of R-star are misleading,6 and it is clear that US household balance sheets are now in a much better state than they were in the lead-up to the GFC. Debt to disposable income for US households has fallen back to 2001 levels (Chart 40), the ratio of total liabilities to net worth has fallen meaningfully for most income categories (panel 2), and the household debt service ratio is now the lowest it has been since the 1970s (Chart 41), underscoring the capacity of US consumers to withstand higher interest rates. It is true that the US corporate sector leveraged itself over the course of the last economic cycle, but at least some of this increase in debt has served to fund capital structure changes, rather than the accumulation of a large stock of “deadweight” excess capacity. Chart 40US Household Balance Sheets Are In Far Better Shape Than They Used To Be Chart 41The US Household Debt Service Burden Is At A 40-Year Low     Investors should certainly be on the lookout for signs that market expectations for “R-star” are rising, but it is not probable that this will occur before the Fed begins to normalize monetary policy. This means that the bond market outlook over the coming year is dependent on the market’s assessment of the timing and pace of Fed rate hikes. Ms. X: You noted earlier that you disagree with the bond market’s outlook for US rate hikes next year. What are the fixed-income portfolio implications of that view? BCA: It is possible that the Fed may begin raising interest rates as early as next summer, but this is only likely to occur if jobs growth meaningfully accelerates, the surge in net retirements during the pandemic is durably sticky (beyond any potential impact from the Omicron variant), or long-dated inflation expectations become unanchored. It is not likely to occur simply because actual inflation, driven significantly by supply-side factors, is elevated. Chart 42A Moderate Rise In US Long-Maturity Bond Yields Next Year For short-maturity bonds, the investment implications of this view are more focused on the real versus inflation components of yields, rather than the existence of major mispricing of 2-year Treasury yields. US government bond yields have risen both at the short- and long-end due to rising inflation expectations, and real yields have fallen. We expect a more significant rise in real than nominal yields over the coming year. As such, investors should sell 2-year inflation protection, which is currently pricing too tepid of a deceleration in the pace of advance of consumer prices. For 10-year US Treasurys, we expect that yields will rise to between 2-2.25% over the coming year, as the Fed moves towards eventual rate hikes. Chart 42 presents FOMC-implied fair value estimates for the 2-, 5-, and 10-year Treasury yield, and underscores that bond yields are set to moderately rise next year. We are uncomfortable with the Fed’s projection of a permanently lower neutral rate of interest, but we see no evidence yet that surging inflation is changing the market’s assessment of the long-run average Fed funds rate. So for now, we recommend that fixed-income investors maintain a short-duration stance, but we do not expect a very severe rise in yields at the long-end of the curve next year. Ms. X: And what positioning would you recommend within a global fixed-income portfolio? BCA: The likely sequencing of central bank rate hikes over the coming 12-18 months suggests that global fixed-income investors should maintain an underweight stance towards US, UK, Canada, and New Zealand, and an overweight stance towards Japan, Europe, and Australia. Among our overweight recommendations, our view that the ECB will lag the Fed makes a clear case to be overweight euro area versus US bonds (both core and periphery), and Chart 43 highlights that rising US bond yields have been strongly correlated with the outperformance of euro area government bonds in US$ hedged terms over the past five years. For Japan, long-maturity JGB yields are likely to remain flat over the next year as they have been since 2016, underscoring that our allocation to JGBs is a strict function of our global duration call (with a short duration stance favoring Japan). In Australia, expectations for monetary policy have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. While there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth and inflation for the RBA to credibly remain on the sidelines next year. As such, we recommend that investors fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Among our underweight recommendations, the fact that the BOE is likely to be the next major developed economy central bank to raise interest rates supports a reduced allocation to UK government bonds. Relative to global government bonds, long-dated gilts have recovered somewhat from their earlier selloff in anticipation of a rate hike in early November, but we expect renewed underperformance in 2022. Unlike in the US, long-dated UK inflation expectations are meaningfully above their average of the past 15 years (Chart 44), which is motivating the BOE’s hawkishness. In Canada, the labor market has fully recovered the jobs lost during the pandemic, and the BOC has grown very concerned about the housing market and the potential for low interest rates to further inflate an already excessive amount of household sector debt. We expect a first rate hike from the BOC in the first half of 2022. Chart 43Rising US Treasury Yields Translates To Hedged Euro Area Government Bond Outperformance Chart 44UK Long-Term Inflation Expectations Are Not Contained Finally, a rate hike cycle has already begun in New Zealand, which also has an important link to the housing market. The New Zealand government has altered the remit of the Reserve Bank of New Zealand (RBNZ) to more explicitly factor in the impact of monetary policy on housing costs, suggesting that the RBNZ will prove to be one of the most hawkish central banks in the developed world over the next couple of years as the central bank attempts to cool off housing demand. Chart 45Speculative-Grade Corporate Bonds Offer Better Value Ms. X: Given the reality of low government bond yields globally, corporate credit has become an increasingly important part of our fixed-income portfolio. My father and I have noticed that corporate bond spreads are very low; should we be making any changes to our allocation to corporate credit? The combination of above-trend economic growth and accommodative monetary policy provides strong support for corporate bond spreads. However, US investment-grade corporate bonds offer essentially no value, and we advise investors to seek out higher returns in speculative-grade corporates. The 12-month breakeven spread for US investment-grade bonds is currently at its 2nd historical percentile (Chart 45), and we currently expect excess returns for IG corporates versus duration-matched Treasuries to be capped at 85 bps. For US high-yield bonds, we recommend an overweight stance within a fixed-income portfolio. We estimate that spreads are currently pricing an expected default rate of 3.1%, assuming a 100 bps risk premium and a 40% recovery rate on defaulted debt. Based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we model that the 12-month default rate will stay between 2.3% and 2.8% next year, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first ten months of this year, well below the estimate generated by our model. The accommodative monetary backdrop provided by the Fed will start to shift at some point in 2022. For now, an elevated 2/10 Treasury slope 85-90 bps suggests that monetary conditions are still accommodative, and our prior work suggests that corporate bond returns are typically strong when the slope is above 50 bps. But when the slope breaks below 50 bps, which could happen as soon as the first half of 2022, we will likely turn more defensive on corporate bonds. A flatter curve suggests a more neutral monetary backdrop, and with valuations already tight it will make sense to take some money off the table. The shifting US monetary policy backdrop leads us to favor European high-yield over US equivalents, as the ECB will be more dovish than the Fed next year. From a fundamental perspective, default rates are projected to be a bit lower in Europe in 2022 (around 2%) compared to the US, in an environment of solid nominal corporate revenue growth and still-moderate borrowing rates. Although valuations are hardly cheap on either side of the Atlantic, we do see better relative value in Ba-rated European junk bonds over similarly rated US credits. 12-month breakeven spreads for European Ba-rated high-yield are in the 38th percentile of its historical distribution, while US Ba-rated junk sits in the 24th percentile. Equity Market Outlook Mr. X: Thank you for your bond market comments. My view that bond yields have potentially much further to rise over the coming few years suggests that we will earn very little in the way of returns from our fixed-income portfolio, but the equity market outlook is no better. In fact, the medium-to-long term equity outlook is probably the worst that I have seen in a long time. Next year’s outlook is arguably bad as well; equity valuation is extreme, and you are forecasting a rise in long-maturity bond yields next year. In addition, you acknowledge that the longer-term term risks of inflation have risen, and believe that the Fed and investors are underestimating the neutral rate of interest. All of that seems wildly bearish to me! Chart 46US Revenue Growth Will Be Stout In 2022... BCA: Let’s address the longer-term outlook for stocks in a moment, and for now focus on what is likely to occur next year. Since the US equity market now accounts for 60% of global stock market capitalization, we will outline our US equity views first before turning to the rest of the world. The starting point for any cyclical view of the stock market should be one’s earnings outlook, and based on our economic view we agree with analyst expectations that US revenue growth will remain elevated next year relative to what has prevailed on average over the past decade (Chart 46). Above-trend growth and consumer price inflation point to revenue growth in the high single-digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, US profit margins have already risen to a new high both for the tech sector (broadly-defined) and ex-tech (Chart 47), and there are credible arguments in favor of an outright contraction in margins over the coming year.7 As such, we expect earnings growth to come in at or below revenue growth, which is currently expected to be about 7% next year. You referenced extreme overvaluation of the equity market, and Chart 48 highlights that the S&P 500 12-month forward P/E ratio is indeed now as high as it was during the stock market bubble of the late-1990s. But panel 2 of Chart 48 highlights that our proxy for the US equity risk premium (ERP) is in line with its historical average, in stark contrast to the lows that were reached in the late-1990s. Chart 47...But Profit Margins Are Extremely Elevated And May Fall Chart 48US Equity Multiples Are Extremely High, But The ERP Is Normal Chart 49Equity Multiples Are High Because Interest Rates Are Extremely Low These seemingly contradictory perspectives are resolved by the observation that real bond yields are extremely low today. It is reasonable to expect a structural decline in real bond yields over time given a structural decline in the potential growth rate of the economy, but Chart 49 highlights that real long-maturity yields are already substantially lower than estimates of trend growth. If we believed that real US government bond yields were set to rise by 200 basis points over the coming year, we would be categorically bearish towards stocks as it would imply a substantially lower P/E ratio. That, however, is very unlikely to occur while the Fed and investors subscribe to the secular stagnation narrative. While R-star is probably higher than the Fed and investors think, we do not think that these expectations will change before the Fed begins to normalize monetary policy. As such, while equity multiples may fall over the coming year in response to somewhat higher bond yields, we expect the decline to be relatively modest. Putting this all together, given our base case view that the pandemic will recede in importance next year, we expect mid-to-high single-digit returns from US equities in 2022 – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Mr. X: You showed the equity risk premium over the past 40 years, which was a period of rising financialization. Given the complacency that I see in markets, especially about the longer-term outlook, I strongly question the view that investors are demanding a normal premium as compensation for potential future volatility. Do your conclusions hold up if you use a much longer time horizon? BCA: They do. Chart 50 shows a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset. This indicates that the ERP today is in line with its long-term median. We do not use the cyclically-adjusted P/E ratio in this calculation; Chart 50 is simply calculated as the 12-month trailing reported earnings yield minus the real long-maturity bond yield. The chart shows that the ERP was quite low in the late-1990s, and above average for several years following the Global Financial Crisis. The conclusion is that while the US P/E ratio is extremely high today, it is so for a very different reason than what occurred in the late-1990s. At that time, the equity risk premium was extremely low, whereas today equity multiples are high because of very low interest rates. You asked about the longer-term outlook for stocks, and Chart 51 presents a range of possible 10-year total returns for US equities, based on a 100-200bps rise in real long-maturity bond yields and revenue growth on the order of 4-5% per year. These scenarios also assume flat profit margins, a constant 2% dividend yield, and a constant ERP. Chart 50The US Equity Risk Premium Is Normal Even Based On 150 Years Of History These returns projections, on the order of 2-5% per year, would beat the returns offered by bonds and thus argue that investors should still be structurally overweight equities versus fixed-income assets. But they would also fall short of the absolute return goals of many investors, and thus we agree that the longer-term outlook for stocks is poor – unless the ERP falls dramatically as real interest rates rise. That would be calling for a return to the ebullient conditions of the late-1990s, and we struggle to envision how this could occur given the myriad economic and geopolitical risks today that did not exist at that time. Ms. X: I want to address the two important global equity calls that did not pan out quite how you expected when we spoke last year: regional equity allocation and value versus growth. What is your view about these positions in 2022? BCA: Financials did modestly outperform broadly-defined technology stocks in 2021, so elements of the value versus growth trade did pan out. But using the MSCI value and growth indexes as benchmarks, value did underperform, and the relative performance of global value versus growth this year has been strongly linked to the 30-year Treasury yield. This has not always been the case in the past, but this year very long-maturity bond yields have done a very good job at explaining the relative performance of value (Chart 52). In addition, Chart 53 highlights the strong correlation between the relative performance of the US equity market and the relative performance of growth since the onset of the pandemic, which is explained by the US’s comparatively large weighting in broadly-defined technology stocks. Chart 52Global Value Versus Growth Is Strongly Correlated With Interest Rates Chart 53Growth / Value Is Impacting Regional Equity Performance Trends     Given our view that long-maturity bond yields are set to rise next year, we find it difficult to bet against value in 2022. At a minimum, a window exists for value’s outperformance, and we do recommend that investors overweight value versus growth next year. Considerable debate exists within BCA about the longer-term outlook for the trend in style, but for next year the majority of BCA strategists expect value to outperform at least for a time. Ms. X: And what about the performance of US stocks versus the rest of the world? BCA: The close link between growth / value and US / global ex-US stocks over the past two years suggests that the US will underperform at some point in 2022 relative to its global peers, although we acknowledge that this case is harder to make. The US did underperform global ex-US in the first quarter of 2021, and again from April to June, but the underperformance eventually gave way to substantial US outperformance. By contrast, the outperformance of global value vs. growth was more sustained in the first half of the year, and the reversal of that performance has been more closely aligned with the trend in bond yields. Our best answer as a firm is that investors should maintain a neutral allocation to the US versus global ex-US for now, with a bias towards increasing exposure to global ex-US at some point next year. Roughly 70% of global ex-US equity market cap is accounted for by DM economies, with the remaining 30% in emerging markets. Given our China economic view, it is difficult to make the case for EM stocks in the first half of 2022. We see more significant easing in China, potentially in Q2, is the most likely upgrade catalyst for EM. Within DM ex-US, the euro area is the most significant region by weight, and there are two arguments in favor of euro area outperformance at some point next year. First, Chart 54 highlights that euro area earnings have more post-pandemic catchup potential than US stocks, suggesting that the US may not fundamentally outperform other DM economies in 2022. Second, Chart 55 highlights that euro area stocks are the cheapest that they have been relative to the US since early-2009 and 2012. In both of these cases, the euro area subsequently outperformed US stocks. Chart 54Euro Area Earnings Have More Catch-Up Potential Chart 55Euro Area Stocks Are Extremely Cheap, And Have Rallied From Similar Valuation Levels     As an additional point about richly valued US equities, it has been argued that a premium is warranted for US stocks given their comparatively high return on equity. But Chart 56 illustrates that this is not the case. The chart shows the relative price-to-book ratio for the US versus developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to other developed markets, underscoring that US stocks are expensive above and beyond what fundamental performance appears to justify. That perspective is echoed in Chart 57, which highlights that the US 12-month forward P/E ratio is 50% above that for global ex-US stocks. Chart 56The Premium Paid For US Stocks Is Not Justified By Higher Return On Equity Chart 57US Stocks Are Extremely Expensive, No Matter How You Slice It Given the news about Omicron, and the recent spike in COVID cases and natural gas prices in the euro area, it may be too early to position in favor of DM ex-US stocks versus the US. But a shift from US to global ex-US stocks should be on investors’ watch list for 2022. Chart 58Industrials Are Likely To Outperform Next Year Mr. X: What about sector positioning, and small caps? BCA: Cyclical sectors have significantly outperformed defensives this year, and we expect further outperformance in 2022. Defensive sectors tend to underperform when bond yields are rising, and we expect that certain cyclical industries will continue to outperform next year. In particular, banks tend to outperform the broad market when interest rates are rising, pent-up demand will boost the consumer services and automobile industries within consumer discretionary, and industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders (Chart 58). Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently. We will discuss our commodity views in a moment, but we expect flat oil prices next year, and our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year. While we generally favor cyclical sectors next year, Chart 59 highlights that the trend in the performance of cyclicals versus defensives (shown in equally-weighted terms) has moved well past its pre-pandemic level, and is now challenging its early-2018 high. Cyclicals have further room to move higher when compared with the levels that prevailed in 2010-2011, but that period reflected resource price levels that we do not expect over the coming year. As such, the performance of cyclicals is getting somewhat late, and we expect to rotate away from cyclical sectors at some point over the coming year. In terms of capitalization, Chart 60 highlights that investors should favor small cap stocks versus large caps over the coming year. The chart highlights that the relative performance of global small caps had rebounded to its pre-trade war levels earlier this year, before falling anew in response to the economic consequences of the Delta wave of COVID-19 and the decline in government bond yields. Abstracting from longer-term trends, small cap stocks tend to outperform large caps over 1-year periods when bond yields are rising, and this has been especially true over the past decade (middle panel). Chart 59Cyclicals Have Some Room To Move Higher Versus Defensives, But Not Much Chart 60Favor Small Caps Over Large Caps In 2022   Our view that government bond yields are set to rise next year, in combination with very attractive relative valuation (bottom panel), makes an overweight small cap stance one of our highest conviction positions with an equity allocation. Currencies And Commodities Mr. X: You mentioned earlier that you expect oil prices to be essentially unchanged next year from the levels that prevailed prior to the discovery of the Omicron variant. I would appreciate it if you could provide the basis for that view, and also your perspective on natural gas prices given how significantly that market is affecting the European economy. Chart 61We Expect Oil To Trade At -81/Bbl Next Year, On Average BCA: Let’s deal first with crude oil prices. First, it should be noted that we will not have good information on Omicron’s impact on oil demand for a few more weeks, which makes it difficult to assess demand for next year as a whole. Prior to this news, our ensemble supply and demand estimates for crude oil projected an increase in supply from core OPEC 2.0 producers in 2022, on target to return to pre-pandemic levels around the middle of the year. Production from non-core OPEC producers will likely be flat to modestly down, consistent with the downward trend that has been in place over the past decade. On the demand side, our base case view suggests flat-to-modestly higher consumption growth in the DM world, and a pickup in non-OECD demand around the middle or back half of the year. Chart 61 highlights that the net result of these forecasts implies that brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. Geopolitical tension with Iran will most likely persist next year, which contributes to upside risk to our forecast. Clearly, Omicron contributes to downside risk. The fact that spot oil prices are likely to be flat next year does not mean that investors cannot profit from energy-related positions. Chart 61 also highlighted that the oil market is currently backwardated, with a downward sloping forward curve that is below our projected spot price for most of 2022. This means that investors can still profit from the roll yield, and we are comfortable recommending the pursuit of a dynamic roll strategy focused on energy contracts (such as the COMT ETF). On the natural gas front, we expect that spot prices will remain elevated through the winter, especially in Europe. The US Climate Prediction Center maintains 90% odds that La Niña will continue through the winter in the Northern Hemisphere, implying a colder-than-normal winter and thus higher-than-normal natural gas demand. Russia’s restriction of supply for geopolitical advantage can continue well in 2022. Chart 62 highlights that European natural gas storage is well below that of previous years, which has contributed to the almost 400% rise in prices this year. European natural gas prices are rising in part due to competition from China because of its power shortage, and are likely to remain high through the winter. Aside from higher-than-average temperatures through the winter months, a reduction in US import demand is the most likely catalyst for lower natgas prices in Europe. The Nord Stream 2 pipeline is unlikely to begin operations early enough to provide relief in H1 2022, although it is possible. Ms. X: One question that I have about the commodity outlook pertains to China. We discussed earlier how China’s economy has slowed this year, and yet metals prices remain in an uptrend. That seems like an aberration, and we would appreciate your thoughts on what is driving the disconnect. BCA: The behavior of industrials metals prices has indeed been confusing for many investors given the slowdown in Chinese economic activity, as evidenced by Chart 63. The annual growth rate of the Bloomberg Industrial Metals Spot Index remains surprisingly elevated given slowing economic activity in China and a meaningful decline in China’s credit impulse. Chart 63Metals Prices Are Seemingly Too High Given A Slowing Chinese Economy   What is missing from this picture is the fact that base metals inventories are very low, due in part to reduced refining activity in China. Charts 64 and 65 present two perspectives on copper inventories: the difference between global production and consumption of refined copper, and the level of warehouse and stock inventories tied to commodity exchanges. Both charts show that inventories have been drawn down heavily this year. Chart 64Global Metals Inventories Have Been Drawing Heavily This Year… Chart 65…And Exchange Inventories Are Very Low     Our expectation that China is likely to slow further over the coming few months arrayed against low metals inventories suggests that the Q1 outlook for metals prices is murky. But as we noted earlier, we expect a reacceleration in Chinese economic activity in the back half of 2022, implying that base metals prices are likely to be higher in 2022 on average. Over a multi-year horizon, we are quite bullish towards base metals – copper in particular – given the critical role that these metals will play in the push to decarbonize the global economy.8 Base metals capex will have to increase at the mining and refining levels to meet renewables and EV demand, and policymakers will need to work towards diversifying metals' production and refining to reduce the concentration risks that currently exist. We strongly suspect that higher prices will have a role in incentivizing higher base metals production, meaning that longer-term investors should follow a “buy copper on dips” strategy. Mr. X: You noted at the outset that gold fell in nominal terms this year, which was surprising to me. My expectation is that gold would have performed better than it did during a year with the strongest inflation in three decades. You referenced the dollar and real interest rates as drivers of the price of gold; please elaborate on that if you can, and what you expect to see from gold in 2022. BCA: It is not particularly surprising to us that the price of gold has fallen this year in the face of surging inflation. We agree that precious metals are a good hedge against inflation over the very long term, but over the cyclical investment horizon the volatility of gold vastly exceeds that of consumer prices. On this point, a comparison to the stock market is apt. It is often the case that changes in P/E ratios are the dominant drivers of equity returns over 6-12 month periods, and in the case of gold it is almost always the case that the real price of gold determines cyclical returns – not changes in the price level. Chart 66Gold Prices Likely Already Reflect An Expectation Of Rising Real Bond Yields Chart 66 highlights that real gold prices have been explained over the past 15 years by changes in the US dollar and especially real 10-year Treasury yields. The chart shows that gold prices are modestly lower today than this historical relationship would imply, possibly reflecting investor unease about the potential for monetary policy tightening next year (above and beyond what is currently reflected by real 10-year yields). Our view that real 10-year yields are likely to rise next year is thus ostensibly bearish for gold, but Chart 66 suggests that some of this effect may already be reflected in prices. As such, we expect that gold prices will be flat-to-modestly down, with the caveat that we would be aggressive buyers on any signs that one or more of today’s major geopolitical risks is materializing (e.g., conflict in the Middle East, Russia’s periphery, or China’s periphery). Chart 67Real Gold Prices Are Extremely Elevated Relative To Their History Over the longer term, Chart 67 highlights that real gold prices are extremely elevated relative to their history. This largely reflects the fact that real interest rates are well below trend rates of economic growth. As such, we are bearish towards gold prices over the secular horizon, given our expectation that real interest rates are likely to move higher over the longer-term. Ms. X: What is your outlook for the US dollar next year? BCA: We recommend that investors stick with short US dollar positions for 2022. However, we acknowledge that the dollar may remain strong over the coming few months, which may persist as long as investors expect near-term economic weakness in the euro area. The Omicron variant impact on global travel, surging COVID cases, and European natural gas prices will likely cause negative near-term economic surprises, but we do not expect these conditions to last over the coming 12 months. Chart 68EUR-USD Is Pricing Too Much Of A Widening In Real Bond Yield Differentials Versus major currencies, the broad trend in the dollar tends to be dominated by the USD-EUR exchange rate, and the recent collapse in the euro has contributed to the broad-based rise in the dollar. Chart 68 highlights that the euro area / US real 10-year government bond yield differential has done a good job of predicting the EUR-USD exchange rate since the Global Financial Crisis, and the chart highlights that the euro has fallen 5% below what this relationship would imply. Using Chart 68 as a guide, current pricing of the euro suggests that investors expect a 40 bps decline in the real 10-year yield differential. We expect US long-maturity real yields to rise on the order of 60-70 bps over the coming year, but the recent behavior of the euro is only fair if euro area real yields are mostly unchanged next year. We would bet against such an outcome, as the economic conditions that will eventually cause the Fed to raise interest rates also imply better economic outcomes for the euro area. Chinese economic growth is likely to be better in the second half of next year, which will boost global growth, and euro area consumers also have ample savings at their disposable to support consumer spending. The fact that euro area stocks have more earnings upside relative to pre-pandemic levels also argues against the dollar from the perspective of equity portfolio flows. Chart 69US Dollar And Indicator The US Dollar Is Overbought Three additional factors support a bearish dollar view beyond a near-term period of temporary dollar strength. The first is that the Fed is likely to lag the Bank of England and Bank of Canada in terms of moving towards normalizing monetary policy, a bearish outlook for USD-GBP and USD-CAD. The second factor is that the US dollar is normally a counter-cyclical currency, and recent dollar strength is implying a degree of equity market weakness that we do not expect next year. Third, Chart 69 highlights that the US dollar is on the verge of entering extremely overbought territory, underscoring that euro bearishness is likely overdone. Mr. X: My daughter and I have been debating adding cryptocurrencies to our portfolio. As you might guess, she sees promise in cryptos, whereas I see them as a bubble waiting to burst. What are your thoughts? BCA: We have had a similar debate at BCA. There is little doubt that the blockchain technologies underpinning cryptocurrencies are here to stay. The only question is whether cryptocurrencies themselves are worth investing in. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.1 trillion, equal to the entire stock of US dollars in circulation. The easy profits in this sector have already been made. Then there is the issue of competition. Many new cryptocurrencies have emerged on the scene since Bitcoin was invented more than a decade ago. Ethereum is the best known, but others such as Solana, Cardano, XRP, and Polkadot are arguably technologically superior. If one invests in this space, at a minimum, one should buy a basket of cryptos, similar to what one would do if one were betting on a new technology but did not know which specific company would ultimately prevail. Mr. X: What about regulation? Is it not just a matter of time before the hammer comes down on the whole sector? BCA: China has banned cryptos, but they continue to thrive, so the sector has proven itself quite resilient to government scrutiny. In fact, regulation could help cryptocurrencies gain the air of respectability, while attracting more institutional investment in the sector. The bigger issue is again, competition, but this time from central banks. Most major central banks are working to develop their own digital currencies. Also keep in mind that governments derive a lot of revenue from “seigniorage” – the ability to create money out of thin air. They would not want to lose that revenue. Mr. X: I am all in favor of depriving governments of the ability to print as much money as they want. But if I wanted to hedge this risk, I would buy gold. BCA: We are inclined to agree, with the caveat that gold itself is already expensive insurance against monetary debasement. Geopolitics Ms. X: I am not sure that I find your arguments about cryptocurrencies to be compelling, but I sense that this is a topic upon which we will have to agree to disagree – at least for now. Perhaps we can close out our discussion with your geopolitical outlook, and what risks my father and I should be most attuned to. BCA: As an overall summary of our view, we contend that the international system will remain unstable in 2022. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor, and is the first of three geopolitical themes that will persist next year and beyond. Multipolarity – or great power struggle – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China (Chart 70). China’s GDP has risen to the top in purchasing power terms and will do so in nominal terms in around five years. China’s potential growth is slowing and financial instability will be a recurring theme in 2022 and beyond. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Since China is ultimately capable of creating an alternative political order in Asia Pacific, the United States is belatedly reacting by penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. Russia and other nationalist powers are also drivers of multipolarity. Chart 71Hypo-Globalization, Our Second Geopolitical Theme The second geopolitical theme is “hypo-globalization,” in which globalization fails to live up to its potential. The trade intensity of global growth peaked with the Great Recession in 2008-10. The stimulus-fueled recovery in the wake of COVID-19 is seeing a trade rebound, which is positive for corporate earnings. But the upside will be limited by the negative geopolitical environment (Chart 71), which makes nations fearful of each other and hungry for self-sufficiency. The 2010s witnessed a retreat from globalization as developed economies saw private debt bubbles unwind, while emerging economies saw trade manufacturing unwind. Anti-globalization movements entered mainstream politics, in both democratic and authoritarian countries, from the East to the West. Today governments are not behaving as if they will engender a new era of ever-freer movement and ever-deepening international linkages. For example, the trade war between the US and China has morphed into a broader competition that limits cooperation to a few select areas, despite a leadership change in the United States. The further consolidation of central government power in China will exacerbate distrust. Chart 72The Risk Of Populism, Our Third Geopolitical Theme, Is Significant In Emerging Markets A third theme is populism, or anti-establishment political sentiment, which we discussed at length last year and is likely to escalate in 2022. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. Most of the developed markets have elected new governments since the pandemic, allowing voters to vent some frustration. But many of the emerging economies are either facing elections or have non-responsive political systems. Either way they may fail to address household grievances. This will be a source of social instability and economic uncertainty in the coming years. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and stands at 15% on average for the major emerging markets, up from around 13% in 2016. The same countries have stimulated their economies, feeding inflationary pressures (Chart 72). Just as the “Arab Spring” unrest destabilized the Middle East and North Africa in the years after the Great Recession, so will new movements destabilize this region or other regions in the wake of COVID-19. Regime failures lead to wars and waves of immigration, which in turn create larger policy changes that can impact markets. Ms. X: What are the investment implications of your geopolitical views? BCA: These three themes – great power struggle, hypo-globalization, and populism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism leads to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and inflation expectations, which is also possible. For example, China’s historic confluence of internal and external political risks has already led to growth disappointments and financial instability. A conflict over the Taiwan Strait, which cannot be ruled out, could begin with deflation and end in inflation, as wars often do. In this respect two geopolitical risks are worthy of repeating: Russia and Iran. Energy producers gain leverage as global energy supplies grow tight. That is why global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 73). This will most likely be the case in 2022. Both of these states are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. If these conflicts explode, they can lead to energy price shortages or shocks, which would clearly raise the odds of the stagflation-lite scenario that we described earlier. Conclusions Mr. X: Thank you very much for another interesting and thorough discussion of the outlook. Our discussion has not swayed me from my deep-seated concern that inflation over the medium-term will be much higher than investors think, and that there are likely to be enormous consequences from this for financial markets. You also acknowledged the long-term risk from a future rise in real interest rates – I suppose I simply see this risk materializing sooner than you do. Ms. X: Even if inflation is only moderately higher over the coming decade, say around 3% on average, that would still seem to have important implications for real portfolio returns. The main purpose of our meeting has been to discuss what will occur in 2022, but last year you provided us with long-term return projections across several asset classes compared with realized historical returns. An update to that would be very much appreciated. BCA: Table 4 presents an update of our long-term return projections based on a 3% inflation scenario, incorporating an allocation to alternative assets. As you highlighted, the projected real portfolio return is just 1% per year over the coming decade, compared with a 6.3% annualized historical real return. The table highlights an important dilemma for investors, which is that government bonds will offer very poor real returns over the coming decade if inflation is higher on average than it has been. Government bonds have traditionally been the core safe-haven assets in investor portfolios, underscoring that global investors may have to accept more volatility to achieve their desired return goals. In our view, this should come in the form of a reduced strategic allocation to US stocks within an equity portfolio, and an increased allocation to alternative assets such as real estate and alternative investments. Table 4Long-Term Return Scenarios In A World With 3% Inflation Ms. X: Thank you. In conclusion, could you summarize your main economic and investment views for 2022? BCA: It would be our pleasure. Our main points are as follows: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. The existence of effective anti-viral treatments, that are not affected by the virus’s mutation, should help limit the impact of Omicron on the medical system. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. Investors are overestimating the magnitude of inflation over the coming 12 months, and we expect actual inflation will come in lower next year than what short-maturity inflation expectations are currently suggesting. Economic growth in advanced economies will be above-trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the back half of next year than over the coming 6 months. China is currently a “one-legged” economy that is supported by external demand, and a shift in advanced economy consumer spending from goods to services may be the catalyst for more aggressive easing from policymakers. Stocks will outperform bonds in 2022, but equity market returns will be in single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may rise in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields – which will not threaten economic activity or cause a major decline in equity multiples. Fixed-income investors should maintain a short duration stance, and position for lower inflation expectations and higher real rates (especially at the short end of the curve). We recommend selling short-maturity inflation protection. Within a government bond portfolio, overweight Europe (core and periphery), Japan, and Australia. Underweight the US, UK, Canada, and New Zealand. Within a credit portfolio, favor speculative-grade over investment-grade corporate bonds, and European Ba-rated European junk bonds over similarly rated US credits. Equity investors should favor small cap over large cap stocks in 2022. Small cap stocks tend to outperform large caps over 1-year periods when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year, but stretched relative performance versus defensives means that we expect to rotate away from cyclical sectors at some point over the coming year. A window exists for value’s outperformance versus growth in 2022 in response to higher long-maturity government bond yields, and we do recommend the former over the latter. Investors should maintain a neutral allocation to the US versus global ex-US for now, with a bias towards increasing exposure to global ex-US at some point next year. An underweight stance towards EM stocks in 1H 2022 is appropriate until clearer signs of Chinese policy easing emerge. Within DM ex-US, we expect euro area outperformance at some point next year: euro area earnings have more post-pandemic catchup potential than US stocks, and relative valuation argues for a euro area bounce. Aside from the potential for Omicron-related near-term economic weakness, a shift in investor expectations for the terminal Fed funds rate is a risk that investors should monitor. Our judgement is that this will probably not occur before the Fed begins to normalize monetary policy. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The oil market is currently backwardated, meaning that investors should pursue a dynamic roll strategy focused on energy contracts. European natural gas prices are likely to remain high through the winter. Aside from higher-than-average temperatures through the winter months, a reduction in US import demand is the most likely catalyst for lower natgas prices in Europe. The outlook for base metals in the first half of 2022 is murky. Metals inventories are low, but China is likely to slow further over the coming few months. Our expectation of a reacceleration in Chinese economic activity in the back half of 2022 means that, on average, base metals prices will be higher in 2022. We expect that gold prices will be flat-to-modestly down next year, although we would be aggressive buyers on any signs that one or more of today’s major geopolitical risks is materializing (e.g., conflict in the Middle East, Russia’s periphery, or China’s periphery). The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. The international system will remain unstable in 2022. Multipolarity, “hypo-globalization”, and populism will remain important geopolitical themes next year (and beyond). The Editors December 1, 2021   Footnotes 1   “South African doctor who raised alarm about omicron variant says symptoms are ‘unusual but mild,” The Telegraph, November 27, 2021. 2   Please see The Bank Credit Analyst "In COVID’s Wake: Government Debt And The Path Of Interest Rates," dated April 29, 2021, available at bca.bcaresearch.com 3  Please see The Bank Credit Analyst "Work From Home “Stickiness” And The Outlook For Monetary Policy," dated June 24, 2021, available at bca.bcaresearch.com 4  June 2021, “Global Economic Impact Trends 2021”, World Travel & Tourism Council 5  What Has Driven the Recent Increase in Retirements? by Jun Nie and Shu-Kuei X. Yang, Federal Reserve Bank of Kansas City Economic Bulletin, August 11, 2021. 6  Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 7   Please see US Equity Strategy "Marginally Worse," dated October 11, 2021, available at uses.bcaresearch.com 8  Please see Commodity & Energy Strategy "COP26 Meets During Policy-Induced Crisis," dated October 28, 2021, available at ces.bcaresearch.com

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

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

Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of.  Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows.    President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress.  We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown.     Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures.  Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans.  Chart 2Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction.      Chart 3Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage.   Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable.   There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran.      Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war.    Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later.   Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly.  After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz.  Chart 9Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China.  The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad.  The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated.  Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector.  Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets.    China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary:    Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed.  Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 12China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening.   China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt ​​​​​​​Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation.    It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally.     Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship.   The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks.   Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com       Footnotes 1     Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2     Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3    Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012).  4    See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org.  5    Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions 

Dear client, This week, we are introducing our new “Currency Month-In-Review” report. The new format should dovetail nicely with the historical back sections you have become accustomed to, but with a more holistic approach to interpreting data releases, along with actionable investment advice. We would appreciate any comments, criticisms, and feedback to help us better serve you. Kind regards, The Foreign Exchange Strategy team   Highlights The DXY index has broken above our 95-threshold level. As a momentum currency, the prospect for further gains in the near term are high. That said, we are sticking with our longer-term (12-18 month) bearish view. Most of the catalysts propping the dollar in the near-term should reverse. The Fed will continue to lag the inflation curve, and economic growth will rotate from the US to other economies that are getting their populations vaccinated. Both are dollar bearish. Speculative positioning in the dollar is now approaching extremes. This warns against establishing fresh long positions. Amidst the volatility in currency markets, trading opportunities are emerging. This week, we are initiating a limit-buy on EUR/CHF trade at 1.05. Feature The latest CPI report from the US was strong, taking markets much by surprise. In the currency world, the spread between the 3-month Eurodollar and Euribor interest rate shot up, pushing up the dollar (Chart 1). December 2022 Eurodollar futures are now pricing in a much faster pace of rate hikes than they did earlier this year. This helped cement the dollar as king this year (Chart 2). Chart 1The Dollar And Interest Rates Chart 2AThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2BThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2CThe Strength In The DXY Is Not Fully Justified By The Economic Picture Chart 2DThe Strength In The DXY Is Not Fully Justified By The Economic Picture Economic data has also been moving in favor of the US of late. The economic surprise index in the US is at 19, while in the eurozone and Japan, it is at -50 and -73.9, respectively. From a broader perspective, the recovery in the services PMI in the US had been more robust than most other developed economies. That said, there are also signs that US economic momentum is giving way to other countries. The US is likely to be the first country to close its output gap, and commensurately, inflation is surprising to the upside (Chart 3). Wage growth has also inflected higher. This is raising the prospect that inflation might be more of a genuine concern. For many other countries, surging house prices are threatening financial stability. In New Zealand, the central bank now has a mandate to consider house prices when calibrating policy. Chart 3AThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3BThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3CThe US Is Generating Genuine Inflation. This Is Depressing Real Rates Chart 3DThe US Is Generating Genuine Inflation. This Is Depressing Real Rates The key point is that many central banks have already withdrawn accommodation ahead of the Fed, which puts the recent dollar rally into question. QE has ended in Canada and New Zealand. Norway and New Zealand have hiked interest rates. Forward curves suggest that most central banks should continue to withdraw accommodation. The key question is whether the Fed turns more hawkish that what is already priced in, or disappoints market expectations. We side with the latter. In the meantime, real rates continue to remain deeply negative in the US. With negative real rates and a deteriorating trade balance, the US will need to significantly raise interest rates to attract portfolio investment. For the US, portfolio investment has mostly been in the form of equity purchases rather than bond flows (Chart 4) and Chart 5). But even an increase in the US 10-year yield to 2.25% will keep real interest rates low. In the following sections, we look at the latest economic releases and provide our assessment of the impact going forward on various currencies. Chart 4AThe Fed Could Disappoint Market Expectations Chart 4BThe Fed Could Disappoint Market Expectations Chart 4CThe Fed Could Disappoint Market Expectations Chart 5AThe US Trade Deficit Needs To Be Financed Externally Chart 5BThe US Trade Deficit Needs To Be Financed Externally Chart 5CThe US Trade Deficit Needs To Be Financed Externally Chart 5DThe US Trade Deficit Needs To Be Financed Externally US Dollar The last month has seen US economic data outperform that of its peers. Within the G10, the Citigroup economic surprise index is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). This has supported the DXY, which is up almost 1% over the last month. For risk-management purposes, we are turning neutral on the DXY in the near term, even though our longer-term view remains bearish. The two most important releases in the US over the last month were the jobs report and this week’s CPI report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October. This is inching closer to NAIRU. Meanwhile, headline CPI came in at 6.2% year-on-year in September while core inflation came in at 4.9%, the highest for several decades. This is occurring within the context of accelerating wage growth (unit labor costs in the nonfarm business sector surged 8.3% in Q3), higher house prices, and an ebullient stock market, reinforcing the wealth effect.  That said, strong domestic demand in the US will have to trigger a much more hawkish Fed for the dollar to reach escape velocity. This is because it will push real interest rates lower as it inflates the US current account deficit. The trade deficit grew 11.2% in September, the sharpest monthly increase since July of 2020. Equity portfolio flows, which have been sustaining the trade deficit, are softening of late. Bond portfolio flows will need a much weaker dollar, or higher Treasury yields, to accelerate. Against such a backdrop, the Fed recently announced a “dovish taper” by reducing the monthly pace of its asset purchases by $15 billion, with the tapering expected to be completed by mid-2022. No imminent rate hike was signaled. The market is likely to continue to challenge such a dovish stance, which will put near-term upward pressure on the dollar, until inflation eventually rolls over. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy. We are sticking to our long-term bearish view on the dollar index, but a more proactive Fed is a risk to this view. We are upgrading our near-term outlook on the dollar to neutral.  Chart 6AUS Dollar Chart 6BUS Dollar Euro The euro has been breaking down in recent sessions and is the main cause of the surge in the DXY index. The euro is down 0.7% over the last month and is currently at 1.145. The key catalyst for the weakness in the euro is the perception that the ECB will severely lag the Fed in normalizing policy settings. This is occurring within the context of surging inflation in the euro area. Headline CPI came in at 4.1% in October, above expectations of 3.7% and well above September’s 3.4% print. The is dampening real rates in the entire eurozone. On the flip side, there is credence to the ECB’s dovish stance given that unemployment is still above NAIRU and eurozone wage growth remains very tepid. On the economy, the recent improvement in both the Sentix and ZEW expectations bode well for euro area activity.  Lower real rates have been the proximate driver of a soft euro in recent trading sessions. That said, real rates could improve if inflation proves transitory. The energy component of the CPI was up 23% year-on-year, by far the biggest contributor to the headline print. Any sign that the ECB is tilting towards a more hawkish direction will initially materialize in the form of reduced asset purchases. This would curtail the significant portfolio outflows from the eurozone this year. From a positioning standpoint, speculative long positions in the euro have also been liquidated, which provides some footing for the currency. We are maintaining a neutral stance on the euro in the very near term, with a bias to buy on weakness.  Chart 7AEuro Chart 7BEuro   Japanese  Yen JPY is the worst-performing currency this year and it is also one of the most shorted. Over the last month, the yen is down 0.4%. Japan is just now emerging from the pandemic, having vaccinated most of its population. Ergo, the economic surprise index, which currently sits at -74, could stage a powerful rebound. While both the inflation print and employment data were in line with expectations (the unemployment rate came in at 2.8% in September), there were other encouraging signs. In October, the Eco Watcher’s Survey rose from 42.1 to 55.5, the manufacturing PMI rose from 51.5 to 53.2, and machine tool orders accelerated 81.5% year-on-year.  The Bank of Japan kept monetary policy unchanged at its latest meeting. The policy stance of the BoJ remains dovish, with little prospect of any interest rate increase until 2025. Therefore, in an environment where interest rates rise, that will hurt the yen at the margin. That said, the underperformance of Japanese assets is attracting portfolio inflows, especially from equity investors. As we wrote last week, the underperformance of certain Japanese equity sectors has not been fully justified by the improving earnings picture. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and it is also quite cheap according to our intermediate-term timing model. Therefore, even given the breakout in the DXY index, we are maintaining our near-term positive for the yen. Chart 8AJapanese Yen Chart 8BJapanese Yen British Pound As a high-beta currency, sterling has been one of the victims of dollar strength. GBP is down 1.6% over the last month. The biggest driver was the volte-face from the BoE. The BoE kept rates on hold despite their seemingly hawkish messaging weeks ahead of the MPC meeting. Gilt yields fell along with the pound. Following the expiry of the furlough scheme in September, the central bank is waiting to the see the potential impact on the labor market before curtailing accommodation. Hence, a hike in December is still on the table. Incoming data continues to strengthen the case for the BoE to tighten policy. CPI is at 3.5%, with the transport and housing sectors continuing to see surging prices. At 4.5%, the unemployment rate is at NAIRU. Wages are also inflecting higher. The latest GDP report (Q3 GDP rose 6.6% year-on-year) continues to suggest the UK economy maintains upward momentum. The October manufacturing PMI rose from 57.1 to 57.8.  Near term, the pound could continue to face weakness as speculators liquidate positions and capital inflows soften. This is especially the case as the post-Brexit environment remains quite volatile. As a play on this trend, we are tactically long EUR/GBP. However, we remain bullish sterling on a cyclical horizon as real rates should continue to normalize. Chart 9ABritish Pound Chart 9BBritish Pound Australian Dollar The Australian dollar is down 0.8% over the last month, as both a stronger dollar and lower iron ore prices exert downward pressure on the exchange rate. The biggest developments over the last few weeks in Australia were the CPI report and the RBA policy meeting. The Q3 print for CPI was 3%, the upper bound of the central bank’s target range, with the trimmed-mean and weighted-median figure coming in at 2.1%. This helped justify the RBA’s decision to abandon the 0.1% yield target on the April 2024 bond. That said, the central bank maintained its cash rate target of 0.1% until earliest 2023 and left the pace of asset purchases unchanged. The RBA trimmed its forecast for GDP for this year to 3% from 4% and said more than 50% of jobs were currently experiencing little to no wage growth. Wages grew just 1.7% in the year to June, far below the 3%-plus levels the RBA believes is necessary to keep inflation sustainably within the 2%-3% band and trigger a rate hike. Hence, the release of the Q3 wage price index, on November 17, will be closely watched. Any upward surprise can challenge the RBA’s measured projections. The bearish case for the Aussie is well known, with speculative positioning near a record short. That said, real yields in Australia have been improving and portfolio flows are accelerating, especially into the mining and energy sectors, which are benefiting from a terms-of-trade tailwind. This sets the stage for a coil-spring rebound in the Aussie. Meanwhile, the AUD is cheap, especially on a terms-of-trade basis. At the crosses, we are long AUD/NZD as a play on these trends. From a tactical standpoint, we are neutral the Aussie, but will buy outright at 70 cents.  Chart 10AAustralian Dollar Chart 10BAustralian Dollar New Zealand Dollar The New Zealand dollar is up 1.3% over the last month. New Zealand’s economy is firing on all cylinders. CPI accelerated sharply from 3.3% to 4.9% in Q3, well above the RBNZ’s target band of 1%-3%, and behind only that of the US. The unemployment rate fell to 3.4% in Q3, far lower than the 3.9% forecasted by economists polled by Reuters. Wage growth was strong in the quarter with the private sector labor cost index registering a 0.7% lift. The seasonally adjusted employment number jumped 2.0% on the quarter, beating expectations of a 0.4% increase. The participation rate also rose to 71.2%, higher than the 70.6% forecast. Meanwhile, house prices continue to move higher, especially in Wellington.  As a result, the RBNZ has been one of the most hawkish G10 central banks, hiking rates last month for the first time in seven years to 0.5%. Another 0.25% hike is likely at the November 24 meeting. Meanwhile, at 2.6%, New Zealand currently has the highest G10 10-year bond yield. This is bullish for the kiwi. The one caveat is that the Covid-19 situation in New Zealand continues to deteriorate, which could be a catalyst for a pause.  Portfolio flows into New Zealand have turned negative in recent quarters. The equity market, which is quite expensive, has underperformed and the currency is overvalued according to our models, which has dampened the appeal of higher yields. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced in. This provides room for disappointment.  Chart 11ANew Zealand Dollar Chart 11BNew Zealand Dollar Canadian Dollar The CAD is the best-performing currency this year, even though it is down 1% over the last month. The key driver of the CAD in recent weeks remains the outlook for monetary policy, and the path of energy prices. CPI inflation came in at 4.4% year-on-year for September, beating market expectations and among the highest across the G10. The CPI-trim hit 3.4% year-on-year. With all eight major components of the CPI rising year-over-year, upward price pressures are broad-based. The housing market also appears bubbly, all providing fertile ground for tighter monetary settings. At first blush, the October employment report was disappointing, with only 31,000 jobs added. However, employment in Canada is already above pre-pandemic levels and is likely to now settle towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs, in line with October’s release. The unemployment rate continues to drop, hitting 6.7%. Incoming data justified the Bank of Canada’s policy response. It delivered a hawkish surprise announcing an end to its quantitative easing program and shifting to the reinvestment phase whereby its holdings of Canadian government bonds will be held constant. It also brought forward the first rate hike to Q2 2022. The BoC will marginally diverge from the US Fed, which is expected to keep rates unchanged through most of next year. This will continue to boost real rates in Canada. Meanwhile, net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. That said, from a tactical standpoint, speculators are marginally long the CAD. As such, our near-term view is cautious. We however doubt the CAD will significantly break below 78 cents, given burgeoning tailwinds.  Chart 12ACanadian Dollar Chart 12BCanadian Dollar Swiss Franc The Swiss franc is up 1% against the dollar over the last month. EUR/CHF has also been very weak in recent trading sessions, constantly testing the 1.054 level. In our view, this has been much more due to euro weakness (see euro section above) than franc strength. The Swiss franc is trading near 11-month highs versus the euro. On the economic front, the labor market is improving and inflation in Switzerland is picking up. House prices have also risen quite robustly. This is lessening the need for the central back to maintain ultra-accommodative settings.  That said, the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. This suggests that market pricing of a 25 basis-point rate rise by the SNB by the end of 2022 is misplaced. Inflation would have to rise substantially more - above the SNB's target range of less than 2% - before any hike is possible. The SNB has also said it remained ready to intervene to weaken a highly valued Swiss franc. The ECB’s dovish stance is one reason why the SNB will be loath to let the currency appreciate. Our guess is that the 1.05 level provides a near-term line in the sand, which will prompt the SNB to intervene. We would be buyers of EUR/CHF below 1.05.  Chart 13ASwiss Franc Chart 13BSwiss Franc Norwegian Krone The Norwegian krone has violently sold off in recent weeks, prompting our long Scandinavian basket to be stopped out. This has been mostly due to low liquidity and the high-beta nature of the krone. Norway’s central bank kept interest rates on hold at its latest meeting but reiterated it will likely hike its key rate by 25 basis points to 0.5% in December. The central bank noted that the economic recovery pushed activity back to pre-pandemic levels, while unemployment receded further. That said, underlying inflation still runs below the bank’s target.  The recent surge in oil prices has provided strong support for Norway’s trade balance and terms of trade. Oil and gas make up around 18% of Norway’s GDP. This is encouraging portfolio flows and has provided underlying support for the NOK. That said, given that much of the Norges Bank’s hawkishness has likely been priced into the NOK, the rewards of going long the currency should start shifting to its carry.  Chart 14ANorwegian Krone Chart 14BNorwegian Krone Swedish Krona The SEK was up 0.9% over the last month. Sweden never closed its economy, yet Covid-19 still had an impact. The good news is that this is mostly behind them. GDP expanded by 1.8% on the quarter in Q3, beating forecasts and the country recently ended all pandemic curbs. The labor market is recovering, and inflation is rising. CPIF inflation, on which the Riksbank sets its 2% target, is at 2.8%. Surging energy prices should turn out to be less of a problem for Sweden than the more coal-dependent countries in Europe, suggesting any increase in prices will be more genuine.  The Riksbank will complete its planned balance-sheet expansion later this year and has committed to maintaining the size of its bond holdings through 2022. The central bank, one of the most dovish amongst the G10, is slated to keep its policy rate flat at least until 2024. This could change if inflationary pressures remain persistent.  The big risk for Sweden is a slowdown in Europe and China. Supply chain bottlenecks are another issue. Several Swedish car and truck makers were forced to halt production in August due to semiconductor shortages. With the recent surge in the dollar, we were stopped out of our short EUR/SEK and USD/SEK positions for a profit. We will be looking to reinstate these trades from higher levels.  Chart 15ASwedish Krona Chart 15BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Kate Sun Research Analyst kate.sun@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Highlights Japan’s long-term weaknesses – a shrinking population, low productivity growth, excess indebtedness – are very well known. However, it still punches above its weight in the realm of geopolitics. Abenomics – sorry, Kishidanomics – can still deliver some positive surprises every now and then. As the global pandemic wanes, and China faces a historic confluence of internal and external risks, investors should begin buying the yen on weakness. Japanese industrials also are an attractive play in a global portfolio. While the yen will likely fare better than the dollar over the next 6-9 months, it will lag other procyclical currencies. Feature Japan has always been an “earthquake society,”  in which things seem never to change until suddenly everything changes at once. The good news for investors is that that change occurred in 2011 and the latest political events reinforce policy continuity. Why “Abenomics” Remains The Playbook Over ten years have passed since Japan suffered a triple crisis of earthquake, tsunami, and nuclear meltdown. In fact, the Fukushima nuclear crisis merely punctuated a long accumulation of national malaise: the country had suffered two “Lost Decades” and was in the thrall of the Great Recession, a rare period of domestic political change, and a rise in national security fears over a newly assertive China. The nuclear meltdown marked the nadir. The result of all these crises was a miniature policy revolution in 2012 – Prime Minister Shinzo Abe and the Liberal Democratic Party (LDP) returned to power and initiated a range of bolder policies to whip the country’s deflationary mindset and reboot its foreign and trade relations. The new economic program, “Abenomics,” consisted of easy money, soft budgets, and pro-growth reforms. It succeeded in changing Japan. Both private debt and inflation, which had fallen during the lost decades, bottomed after the 2011 crisis and began to rise under Abe (Chart 1). By the 2019 House of Councillors election, however,  Abe was running out of steam. Consumption tax hikes, the US-China trade war, and COVID-19 thwarted his plans of national revival. In particular, Abe hoped to capitalize on excitement over the 2020 Tokyo Olympics to hold a popular referendum on revising the constitution. Constitutional revision is necessary to legitimize the Self-Defense Forces and thus make Japan a “normal” nation again, i.e. one that can maintain armed forces. But the global pandemic interrupted. Until the next heavyweight prime minister comes along, Japan will relapse into its old pattern of a “revolving door” of prime ministers who come and go quickly. For example, the only purpose of Abe’s immediate successor, Yoshihide Suga, was to tie off loose ends and oversee the Olympics before passing the baton (Chart 2). Chart 1Abenomics Was Making Progress The next few Japanese prime ministers will almost inevitably lack Abe’s twin supermajority in parliament, which was exceptional in modern history (Chart 3). It will be hard for the LDP to expand its regional grip given that it holds a majority in all 11 of the regional blocks in which the political parties contend for seats based on their proportion of the popular vote (Table 1). Table 1LDP+ Komeito Regional Performance Short-lived, traditional prime ministers will not be able to create a superior vision for Japan and will largely follow in Abe’s footsteps.   In September Prime Minister Fumio Kishida replaced Suga – a badly needed facelift for the ruling Liberal Democrats ahead of the October 31 election. The LDP retained its single-party majority in the Diet, so Kishida is off to a tolerable start (Chart 4). But he is far from charismatic and will not last long if he fumbles in the upper house elections in July 2022. This gives him a little more than half a year to make a mark. Kishida will oversee a roughly 30-40 trillion yen stimulus package, or supplemental budget, by the end of this year. Japanese stimulus packages are almost always over-promised and under-delivered. However, given the electoral calendar, he will put together a large package that will not disappoint financial markets. His other goal will be to build on recent American efforts to cobble together a coalition of democracies to counter China and Russia. Japan’s Grand Strategy In Brief Chart 5Japan Exposed To China Trade Japan’s grand strategy over centuries consists of maintaining its independence from foreign powers, controlling its strategic geographic approaches to prevent invasion, and stopping any single power from dominating the eastern side of the Eurasian landmass. Originally the hardest part of this grand strategy was that it required establishing unitary political control over the far-flung Japanese archipelago. However, since the Meiji Restoration, Tokyo has maintained centralized government. Since then Japan has focused on controlling its strategic approaches and maintaining a balance among the Asian powers. During the imperialist period it tried to achieve these objectives on its own. After World War II, the United States became critical to Japan’s grand strategy. Through its broad alliance with Washington, Tokyo can maintain independence, make sure critical territories are not hostile (e.g. Taiwan and South Korea), and deter neighboring threats (North Korea, China, Russia). It can at least try to maintain a balance of power in Eurasia. Yet these constant national interests underscore Japan’s growing vulnerabilities today: China’s economy is now two-times larger than Japan’s and Japan is more dependent on China’s trade than vice versa (Chart 5). Under Xi Jinping, Beijing is actively converting its wealth into military and strategic capabilities that threaten Japan’s security. Rising tensions across the Taiwan Strait are fueling nationalism and re-armament in Japan.  Russia’s post-Soviet resurgence entails an ever-closer Russo-Chinese partnership. It also entails Russian conflicts with the US that periodically upset any attempts at Russo-Japanese détente. North Korea’s asymmetric war capabilities and nuclearization pose another security threat. South Korea’s attempts to engage with the North and China, and compete with Japan, are unhelpful.    All of these realities drive Japan closer to the United States. Even the US is increasingly unpredictable, though not yet to the point of causing serious doubts about the alliance. If the US were fundamentally weakened, or abandoned the alliance, Japan would either have to adopt nuclear weapons or accommodate itself to Chinese hegemony to meet its grand strategy. Nuclearization would be the more likely avenue. The stability of Asia depends greatly on American arbitration. Japan’s Strategy Since 1990 Beneath this grand strategy Japan’s ruling elites must pursue a more particular strategy suited to its immediate time and place. Ever since Japan’s working population and property bubble peaked in the early 1990s, the country’s relative economic heft has declined. To maintain stability and security, the central government in Tokyo has had to take on a very active role in the economy and society. The first step was to stabilize the domestic economy despite collapsing potential growth. This has been achieved through a public debt supercycle (Chart 6). Unorthodox monetary and fiscal policy largely stabilized demand, at the cost of the world’s highest net debt-to-GDP ratio. The economic adjustment was spread out over a long period of time so as to prevent a massive social and political backlash. Unemployment peaked in 2009 at 5.5% and never rose above this level. The ruling elite and the Liberal Democrats maintained control of institutions and government. The second step was to ensure continued alliance with the United States. Japan could deal with its economic problems – and the rise of China – if it maintained access to US consumers and protection from the US military. To maintain the alliance required making investments in the American economy, in US-led global institutions, and cooperating with the US on various initiatives, including controversial foreign policies. As in the 1950s-60s, Japan would bulk up its Self-Defense Forces to share the burden of global security with the United States, despite the US-written constitution’s prohibition on keeping armed forces. The third step was to invest abroad and put Japan’s excess savings to work, developing materials and export markets abroad while employing foreign workers and factories to become Japan’s new industrial base in lieu of the shrinking Japanese workforce (Chart 7).  Chart 6Japan's Public Debt Supercycle Japan’s post-1990 strategy has staying power because of the massive pressures on Japan listed above: China’s rise, Russo-Chinese partnership, North Korean threats, and American distractions. Investors tend to underrate the impact of these trends on Japan. Unless they fundamentally change, Japan’s strategy will remain intact regardless of prime minister or even ruling party. Russia’s role is less clear and could serve as a harbinger of any future change. President Vladimir Putin and Abe had the best chance in modern memory to resolve the two countries’ territorial disputes, build on mutual interests, and maybe even sign a peace treaty. But Russia’s clash with the West  proved an insurmountable obstacle. New opportunities could emerge at some later juncture, as Japan’s interest in preventing China from dominating Eurasia gives it a strong reason to normalize ties with Russia. Russia will at some point worry about overdependency on China. But this change is not on the immediate horizon.  Japan’s Tactics Since 2011 Japan is nearly a one-party state. Brief spells of opposition rule, in 1993 and 2009-11, are exceptions that prove the rule. The Liberal Democrats did not fall from power so much as suffer a short “time out” to reflect on their mistakes before voters put them right back into power. However, these timeouts have been important in forcing the ruling party to adjust its tactics for changing times, as with Abenomics. Kishida will not have enough political capital to change direction. The emphasis will still be on defeating deflation and rekindling animal spirits and corporate borrowing (as opposed to relying exclusively on public debt). Kishida has talked about a new type of capitalism and a more active redistribution of wealth, in keeping with the current zeitgeist among the global elite. However, Japan lacks the impetus for dramatic change. Wealth inequality is not extreme and political polarization is non-existent (Chart 8). The LDP is wary of losing votes to the populist Japan Innovation Party, or other regional movements, but populism does not have as fertile ground in countries with low inequality.  The desire to boost wages was a central plank of Abenomics (Chart 9) and an area of success. It will come through in Kishida’s policies as well. But the ultimate outcome will depend on how tight the labor market gets in the upcoming economic cycle. Similarly Kishida can be expected to encourage, or at least not roll back, women’s participation in the labor force, as labor markets tighten (Chart 10). As the pandemic wanes it is also likely that he will reignite Abe’s loose immigration policy, which saw the number of foreign workers triple between 2010 and 2020. This inflow is perhaps the surest sign of any that insular and xenophobic Japan is changing with the times to meet its economic needs.  Chart 9Kishidanomics To Build On Abe's Wage Growth Chart 10Women Off To Work But Fertility ##br##Relapsed The only substantial difference between Kishidanomics and Abenomics is that Abe compromised his reflationary fiscal efforts by insisting on going forward with periodic hikes to the consumption tax. Kishida is under no such expectation. Instead he is operating in a global political and geopolitical context in which ambitious public investments are positively encouraged even at the expense of larger budget deficits (Chart 11). Yet interest rates are still low enough to make such investments cheaply. The stage is set for fiscal largesse. Chart 11Fiscal Largesse To Continue Kishida can be expected to promote large new investments in supply-chain resilience, renewable energy, and military rearmament. The US and EU may exempt climate policies from traditional budget accounting – Japan may do the same. Even more so than China and Europe, Japan has a national interest in renewable energy since it is almost entirely dependent on foreign imports for its fossil fuels. The green transition in Japan is lagging that of Germany but the Japanese shift away from nuclear power has gone even faster, creating an import dependency that needs to be addressed for strategic reasons (Chart 12). Monetary-fiscal coordination began under Abe and can increase under Kishida. What is clear is that public investment is the top priority while fiscal consolidation is not. Military spending is finally starting to edge up as a share of GDP, as noted above. For many years Japanese leaders talked about military spending but it remained steady at 1% of GDP. Now, at the onset of the US-China cold war, the Japanese are spending more and say the ratio will rise to 2% of GDP (Chart 13). Tensions with China, especially over Taiwan, will continue to drive this shift, though North Korea’s weapons progress is not negligible. The Biden administration is prioritizing US allies and the competition with China, which makes the Japanese alliance top of mind. Tokyo’s various attempts to talk with Beijing in recent years have amounted to nothing, with the exception of the Regional Comprehensive Economic Partnership, which is far from ratification and implementation. Japan’s relations with China are driven by interests, not passing attitudes and emotions. If Biden proves too dovish toward China – a big “if” – then it will be Japan pushing the US to take a more hawkish line rather than vice versa. Japan will take various strategic, economic, technological, and military actions to defend itself from the range of external threats it faces. These actions will intimidate and provoke China and other neighbors, which will help to entrench the “security dilemma” between the US and China and their allies. For example, Japan will eagerly participate in US efforts to upgrade its military and its regional alliances and partnerships, including via the Quadrilateral Security Dialogue with India and Australia. The Biden administration might force Japan to play nice with South Korea and patch up their trade war. But that is a price Japan can pay since American involvement also precludes any shift by South Korea fully into China’s camp. If China should invade Taiwan – which we cannot rule out over the long run – Japan’s vital supply lines and national security would fall under permanent jeopardy. Japan would have an interest in defending Taiwan but its willingness to war with China may depend on the US response. However, both Japan and the US would have to draw a stark line in defense of Japanese territory, not least Okinawa, where US troops are based. Both powers would mobilize and seek to impose a strategic containment policy around China at that point. Until The Next Earthquake … For Japan to abandon its post-1990 strategy, it would need to see a series of shocks to domestic and international politics. If China’s economy collapsed, Korea unified, or the US abandoned the Asia Pacific region, then Tokyo would have to reassess its strategy. Until then the status quo will prevail. At home Japan would need to see a split within the Liberal Democrats, or a permanent break between the LDP and their junior partner Komeito, combined with a single, consolidated, and electorally viable opposition party and a charismatic opposition leader. This kind of change would follow from major exogenous shocks. Today it is nowhere in sight – the last two shocks, in 2011 and 2020, reinforced the LDP regime. Theoretically some future Japanese government could adopt a socialist platform that relies entirely on public debt rather than trying to reboot private debt. It could openly embrace debt monetization and modern monetary theory  rather than trying to raise taxes periodically to maintain the appearance of fiscal rectitude. But if it tried to distance itself from the United States and improve relations with Russia and China, such a strategy would not go very far. It would jeopardize Japan’s grand strategy. For the foreseeable future, Japan’s economic security and national security lie in maintaining the American alliance and continuing an outward investment strategy focused on emerging markets other than China. Macroeconomic Developments The key message from an economic context is that fiscal stimulus is likely to be larger in Japan than the market currently expects. The IMF is penciling in a fiscal deficit of around 2% of potential GDP next year, which will be a drag on growth (Chart 14). More likely, Kishida will cobble together a slightly larger package to implement most of the initiatives he has proposed on the campaign trail. Meanwhile, a large share of JGBs are about to mature over the next couple of years, providing room for more issuance, which the BoJ will be happy to assimilate (Chart 15). Chart 14More Fiscal Stimulus In Japan Likely Chart 15Lots Of JGBs Mature In The Next Few Years Real numbers on the size of the fiscal package have been scarce, but it should be around 30-40 trillion yen, spread over a few years. With Japan’s net interest expense at record lows (Chart 16), and a lot of the spending slated for worthwhile productivity-enhancing projects such as supply chains, green energy, education and some boost to the financial sector in the form of digital innovation and consolidation, we expect fiscal policy in Japan will remain moderately loose, with the BoJ staying accommodative. The timing of more fiscal stimulus is appropriate as Japan has managed to finally put the pandemic behind it. The number of new Covid-19 cases is at the lowest recorded level per capita, and Japan now  has more of its population vaccinated than the US. As a result, the manufacturing and services PMIs, which have been the lowest in the developed world, could stage a coiled-spring rebound. This will be a welcome fillip for Japanese assets (Chart 17). Chart 16Little Cost To Issuing More Debt Chart 17The Japanese Recovery Has Lagged Consumption could also surprise to the upside in Japan. With the consumption tax hike of 2019 and the 2020 pandemic now behind us, pent-up demand could finally be unleashed in the coming quarters. Rising wages and high savings underscore that Japan could see a vigorous rebound in consumption, as was witnessed in other developed economies. This will be particularly the case as inflation stays low. The big risk for Japan from a macro perspective is an external slowdown, driven by China. A boom in foreign demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows, especially as a big share of Japanese exports go to China. Our view has been that policy makers in China will be able to ring-fire the property crisis, preventing a “Lehman” moment. As such, while China’s slowdown is a reality and downside risks warrant monitoring, we also expect China to avoid a hard landing. Meanwhile, Japanese exports are also diversified, with other developed and emerging markets accounting for the lion’s share of total exports. For example, exports to the US account for 19% of sales while EU exports account for 9%. Both exports and foreign machinery orders remain quite robust, suggesting that the slowdown in China will not crush all external demand (globally, export growth remains very strong).  It is noteworthy that many countries now have “carte blanche” to boost infrastructure spending, especially in areas like renewable energy and supply chain resiliency. Japan continues to remain a big supplier of capital goods globally. This will ensure that an economic recovery around the world will buffer foreign machinery orders. Market Implications Japanese equities have underperformed the US over the last decade, and Kishidanomics is unlikely to change this trend. But to the extent that more fiscal stimulus helps lift aggregate demand, a few sectors could begin to see short-term outperformance. More importantly, the underperformance of certain Japanese equity sectors have not been fully justified by the improving earnings picture (Chart 18). This suggests some room for catch-up. Banks in particular could benefit from a steeper yield curve in Japan, rising global yields and proposed reform in the sector (Chart 19). We will view this as a tactical opportunity however, than a strategic call. Our colleagues in the Global Asset Allocation service have clearly outlined key reasons against overweighting Japan, and are currently neutral.  More importantly, industrials also look poised to see some pickup in relative EPS growth, as global industrial demand stays robust. An improvement in domestic demand should also favor small caps over large caps. Chart 18ADismal Earnings Explain Some Underperformance Of Japanese Equities Chart 18BDismal Earnings Explain Some Underperformance Of Japanese Equities Chart 19Japanese Banks Will Benefit From A Steeper Yield Curve Foreigners have huge sway over the performance of Japanese assets, especially equities. Foreign holders account for nearly 30% of the Japanese equity float. This is important not only for the equity call but for currency performance as well since portfolio flows dominate currency movements. Historically, the yen and the Japanese equity market have been negatively correlated. This was due to positive profit translation effects from a lower currency. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but rather by underlying productivity gains. This could result in less yen hedging by foreign equity investors, which would restore a positive relationship between the relative share price performance and the currency. As for the yen, the best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Historically, now has been the exact environment where the yen tends to do well, as the economy exits deflation and enters non-inflationary growth (Chart 20). Chart 20The Yen And Japanese Growth Markets have been wrongly focusing on nominal rather than real yields in Japan and the implication for the yen. Therefore the risk to a long yen view is that the Bank of Japan keeps rates low as global yields are rising. However, in an environment where global inflationary pressures normalize (say in the next 6-9 months) and temper the increase in global yields, this could provide room for short covering on the yen. In our view, the yen is already the most underappreciated currency in the G10, as rising global yields have led to a massive accumulation of short positions. Finally, from a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and is also quite cheap according to our intermediate-term timing model (Chart 21). With the yen being a risk-off currency, it also tends to rise versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. This low-beta nature of the currency makes it a good portfolio hedge in an uncertain world. Chart 21The Yen Is Undervalued Given the historic return of geopolitical risk to Japan’s neighborhood, as the US and Japan engage in active great power competition with China, the yen is an underrated hedge. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chester Ntonifor Vice President Foreign Exchange Strategy chestern@bcaresearch.com

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

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

Special Report

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