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Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Chart 4Liquidity Deterioration At The Margin Chart 5Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Chart 2Natgas Storage Remains Tight US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 Chart 6       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth Chart 6US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Chart 10       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Bank Credit Analyst

Highlights The decline in the US and UK July services PMIs underscores that pandemic control measures are not the only manner by which COVID-19 impacts the services sector of the economy. A slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. The fact that highly-vaccinated advanced economies have experienced a sharp rise in new cases due to the Delta variant underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. The vaccination rate is the most obvious indicator of progress towards NAHRI, but immunity from previous infections is also an important contributor. Reasonable estimates of unreported COVID-19 infections suggest that investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Extremely easy monetary policy, pent up savings, and robust revenue growth will support economic growth and the trend in stock prices – despite the fact that analyst earnings expectations are clearly too high. The recent underperformance of China-sensitive assets has been driven by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts. Chinese stocks are now oversold and could bounce in the near-term, but we would still recommend favoring developed market equities within a global ex-US equity allocation until Chinese policy turns reflationary. Investors should continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from the Delta variant is likely to cause a near-term growth disappointment. High single-digit earnings growth, coupled with some pressure on multiples, continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks, whose outperformance is not dependent on that of EM. Value versus growth, and small caps versus large, will likely benefit from an uptrend in long-maturity bond yields. We recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Feature Chart I-1Meaningful Vaccination Progress Continues Everywhere Except Africa Over the past month, the Delta variant-driven phase of the pandemic has continued to worsen in several advanced economies, arrayed against a continual improvement in the immunity of the world’s population. Chart I-1 highlights that, outside of Africa, the share of the population that is fully vaccinated against COVID-19 is rising at a robust pace of roughly 10 percentage points per month. But in advanced economies with elevated rates of vaccination compared to the rest of the world, new confirmed cases of COVID-19 accelerated in August, driven in most cases by the Delta variant. Chart I-2 highlights that in the UK, the epicenter of the Delta surge, new cases have begun to rise again after having peaked in late July. UK hospitalizations remain low relative to what has occurred since the onset of the pandemic (panel 2 of Chart I-2), but the US has experienced a more significant rise due to its comparatively low vaccination rate. In addition, reflecting a disparity in vaccination rates within the US that we have highlighted, has a strong political dimension.1 Chart I-3 illustrates that ICU capacity utilization (relative to peak staffed ICU beds) has risen sharply in red states, back above its all-time high. ICU usage in blue states is also rising, but it remains 10 percentage points below its prior peak. Chart I-2UK Hospitalizations Remain Stable, Despite Elevated Case Counts Chart I-3Lowly Vaccinated US States Are Suffering The Most From Delta   When discussing the pandemic and its economic impact in past Bank Credit Analyst reports, we have emphasized the importance of hospitalizations as the core driver of policymaker decisions about pandemic control measures. In turn, we have focused on control measures as an important driver of economic activity because these measures clearly impede households’ ability to consume many services. Chart I-4Surging Cases Impact Services Activity, Even Without Pandemic Control Measures But Chart I-4 underscores that control measures are not the only manner by which the pandemic impacts the services sector of the economy. The chart highlights that the Markit services PMI has fallen sharply in July and August in both the US and UK economies, two countries that have few or no pandemic control measures still in place. This is strong evidence that fear and general risk aversion among some consumers is affecting services spending. Given that hospitalizations have remained relatively well controlled in the UK, this also suggests that the impact on consumer sentiment is emerging mostly from new case counts rather than from published hospitalization rates. Chart I-5 highlights that the University of Michigan's Index of Consumer Sentiment fell sharply in August to essentially a 10-year low, providing further evidence that a slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. Chart I-6 highlights that this has not yet been reflected in consensus expectations for growth, suggesting that near-term growth disappointments are likely. Chart I-5A Q3 Growth Slowdown Is Now All But Inevitable... Chart I-6...Which Is Not Currently Reflected In Consensus Expectations For Growth   Shifting Focus From Herd Immunity To NAHRI The fact that highly vaccinated advanced economies have experienced a sharp rise in new cases due to Delta underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. This point was underscored earlier this month in public comments by the head of the Oxford Vaccine Group,2 who noted that even relatively small rates of transmission from “breakthrough cases” of vaccinated individuals means that anyone who is unvaccinated will likely be exposed to COVID-19 at some point over the coming months or years. From an economic standpoint, this may not be problematic if the spread of the disease among the unvaccinated is slow, as it would allow hospitals time to process COVID patients without risking an overrun of the system (and thus would likely not necessitate a response from policymakers). But the lack of an achievable herd immunity is clearly a risk if community transmission of the Delta variant is high among unvaccinated individuals, even in a scenario where overall vaccination rates are elevated. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. This concept is borrowed from the idea of NAIRU (the non-accelerating inflation rate of unemployment), and signifies the point at which sufficient immunity has been reached in a country – either through vaccination or past infection – that results in a stable pace of COVID-19 hospitalizations in the absence of any pandemic control measures or precautionary behavior on the part of consumers. Once NAHRI is reached with no control measures and a pre-pandemic rate of interpersonal contact, the pandemic will be effectively over. Chart I-7The US Vaccination Rate Has Picked Up Modestly One clear difficulty with this perspective is that NAHRI is unknown, making it challenging to determine how close a given economy is to a stable pace of COVID-related hospitalization. The experience of the UK over the past month, with an elevated case count yet stable hospitalizations, may suggest that they are close or approaching a stable-hospitalization immunity rate, although investors will still need to watch the UK closely over the coming weeks to confirm if this is the case. The vaccination rate is the most obvious indicator of progress toward NAHRI, and on this front the US has further to go. Chart I-7 highlights that while the pace of first doses administered in the US has risen over the past two months in response to the Delta wave, it will still take until the end of October or early November for the US to reach levels that have been attained by other advanced economies. The introduction of widespread vaccination mandates, as well as the incentive effects of vaccination passports, might raise this rate over the coming weeks. This is even more likely given the FDA's full approval of the Pfizer/BioNTech vaccine this week. But; immunity from previous infections will also contribute to reaching NAHRI, which raises the question of how many unreported COVID-19 infections have occurred since the onset of the pandemic. This is especially important given recent evidence that a previous COVID-19 infection among those who are unvaccinated appears to provide as much protection against the Delta variant as double-dose vaccination does for those without a previous infection (Chart I-8). Chart I-8A Previous COVID-19 Infection Appears To Offer Strong Protection Against The Delta Variant In the US, the Center for Disease Control estimates that from February 2020 to May 2021 only 1 in 4.2 COVID-19 infections were reported, suggesting that there were approximately 120 million total infections during that period. That would be quite positive for the economic outlook if accurate, as it would imply that the true immunity rate in the US is probably much closer to NAHRI than the vaccination rate would imply. However, it is also possible that the Center's estimate is too high, which is what some surveys of Americans seem to suggest. In mid-to-late February, a Pew Research survey reported that 25% of US adults had either tested positive for COVID-19, tested positive for antibodies against the SARS-COV-2 virus, or were confident that they already contracted the virus. This compares with 8.5% of the US population with a confirmed case of COVID-19 at that time, suggesting that the true ratio of reported cases to total infections is closer to 1:3. Chart I-9 highlights what the true US immunity rate might look like compared with the published vaccination rate based on different estimates of unreported infections. The chart highlights that a 1:3 ratio of reported cases to total infections implies an additional 10 percentage points of immunity, which would bring US first-dose vaccination rates in line with those of other DM countries. When combined with a slow but still ongoing rise in first doses administered, as well as emergency use eligibility of children under 12 years old targeted by the end of September, investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. Chart I-9The True US Immunity Rate May Be A Lot Higher Than The Vaccination Rate Would Suggest A Permanent Shift In Consumer Behavior? The inability to reach true herd immunity, combined with the recent slowdown in services activity in response to a surge in cases from the Delta variant, raises the issue of whether altered consumer behavior will persist beyond the next few months. Chart I-10A Positive Sign That The Delta Wave May Be Abating In our view, the answer is: probably not. First, Chart I-10 makes the simple point that the transmission rate is already falling in advanced economies, suggesting that fears of a complete explosion in new cases beyond previous highs are unfounded. Second, the behavior of consumers over the past two months has been reasonable, but is unlikely to continue once nations begin to approach NAHRI. The Delta variant is still relatively new, and its higher transmissibility, as well as its seemingly higher hospitalization rate for those who are unvaccinated, has understandably given some consumers pause over the past few months (even those who are vaccinated). This is likely especially true among adults with young children in their household, given that they are not currently able to receive a vaccine and given a significant rise in pediatric cases that has occurred in some countries. But the reality is that the world will have to live with the existence of COVID-19 permanently, which consumers, investors, and policymakers will all soon come to accept and normalize. It will become endemic, and receiving annual booster shots against the disease may become a permanent ritual for people around the world. In advanced economies, once most or all individuals who wish to be vaccinated have had the chance to receive their shot, it seems unlikely that periodic waves of rising cases among the unvaccinated will be seen as a threat to individual health, especially if the increase in hospitalizations is limited and the viability of the health care system is not under threat. Beyond Delta: The Economy And Financial Markets In A Year’s Time On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Instead, the cyclical investment outlook will continue to depend on the factors that we have discussed in several previous reports: Extremely Easy Monetary Policy: Chart I-11 illustrates the 10-year US Treasury yield relative to trend nominal GDP growth. The chart highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s, which will continue to support domestic demand even if growth moderates over the coming year. Excess Savings: A waning growth impulse from fiscal policy will likely weigh on real goods spending, which is roughly 10 percent higher than its pre-pandemic trend (Chart I-12). But services spending, which accounts for about 70% of overall consumer spending, is still 5% below its pre-COVID trend and will be supported by the deployment of a significant amount of excess savings that have accumulated over the course of the pandemic. Some of these excess savings have probably been deployed to pay down debt, but a sizeable portion likely remains to support services spending. Chart I-13 highlights that the gap in spending is fairly broad-based across different services categories, underscoring that a recovery in services spending is not overly-dependent on the return of a particular type of consumer spending behavior. Chart I-11US Monetary Policy Is Extraordinarily Easy Chart I-12Pent-Up Savings Will Support Services Spending   Robust Revenue Growth: The equity market is likely to be supported by strong revenue growth over the coming year, even if it modestly disappoints current expectations. Chart I-14 presents bottom-up analysts’ expectations for S&P 500 sales per share growth over the coming year, alongside a proxy for nominal growth expectations (12-month forward expectations for real GDP growth plus 2 percentage points). The chart highlights that, while expectations for sales growth are modestly above what our proxy would suggest, nominal growth expectations are the strongest they have been in over a decade. Chart I-13Missing Services Spending Is Broad- Based Across Spending Categories Chart I-14S&P 500 Revenue Growth Is Likely To Be Strong Over The Coming Year...   On the latter point, while revenue growth will likely support the equity market, expectations for earnings are now clearly too high. Chart I-15 highlights that bottom-up analysts are calling for 18% earnings growth over the coming year – after what has already been a very impressive earnings recovery – and for profit margins to expand by a full percentage point from what is already a new high. Chart I-16 presents a long-term perspective on corporate profit margins, highlighting how stretched they have become even relative to the uptrend of the past three decades. Chart I-15...Even Though Earnings Expectations Are Clearly Too High Chart I-16US Profit Margins Are Very Elevated, Even Given The Past Three Decade's Uptrend     Chart I-17 highlights that earnings expectations usually disappoint, given the perennial optimism of bottom-up analyst expectations. The chart shows that they historically disappoint on the order of 5 percentage points, but that a 10 percentage point miss would not be so uncommon. Thus, EPS growth that is in line with the revenue growth proxy shown in Chart I-14 will not likely weigh on investor sentiment. China And EM Stocks As a final point about the macro and cyclical investment outlook, Chart I-18 highlights that our Market-Based China Growth Indicator has fallen below the boom/bust line for the first time since the middle of last year. We highlighted in last month’s report that China would not likely provide the global economy with a growth impulse until Chinese policy turns reflationary, and financial assets that are sensitive to Chinese economic growth are now flashing a warning sign. We therefore continue to believe that a normalization in services spending in advanced economies remains the likely impulse for global growth over the coming year. Chart I-17A 10% Earnings Miss Over The Coming Year Would Not Be Unprecedented Chart I-18Chinese Growth Proxies Are Performing Poorly   However, at least a part of the recent underperformance of China-sensitive assets has been driven by the spectacular underperformance of broadly-defined tech stocks in China since late-May (Chart I-19). The selloff in Chinese tech stocks has been triggered by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts in China – which are thus not likely to be transitory. Still, Chinese stocks are now oversold even in absolute terms (Chart I-20), raising the question of whether EM stocks overall are due for a bounce. Chart I-19Some Of The Recent EM Underperformance Reflects The Chinese Regulatory Crackdown Chart I-20Chinese Stocks Are Oversold In Absolute Terms     In the short term, the answer is yes, but over a 6-12 month time horizon we would still recommend favoring developed market equities within a global ex-US equity allocation. First, while policy from China may eventually act as a catalyst for EM equities, BCA’s China strategists do not believe that Chinese policymakers have yet reached the “pain point” that would signal regulatory and monetary policy easing. Second, China and EM more generally is comparatively tech heavy, and thus will face headwinds on a relative basis if value outperforms growth over the coming year (as we expect). Chart I-21EM Stocks Do Not Offer A Compelling Value Catalyst Versus DM Ex-US Third, Chart I-21 highlights that EM stocks offer no compelling value proposition relative to DM ex-US equities. EM stocks are modestly cheap on a 12-month forward P/E basis (trading at a 13% discount), but this has been true historically – with the exception of a brief period from mid-2007 to mid-2008. Relative to the past decade, EM valuation is at roughly average levels versus global ex-US stocks, suggesting that Chinese policy and sector performance trends are likely to be the key drivers for EM performance relative to non-US equities. Investment Conclusions Chart I-22Favor DM Ex-US Vs. US, And Value Vs. Growth, Over The Coming Year In Section 2 of this month’s report, we explain why the Fed’s maximum employment criterion is likely to be reached earlier than investors and the Fed itself expects. This suggests that equity multiples may come under pressure over the coming year as long-maturity government bond yields rise. However, we noted above that earnings are likely to grow at a high single-digit pace, and that this is likely to support the uptrend in US stock prices as developed economies approach or surpass the non-accelerating hospitalization rate of immunity from COVID-19 and the world continues to move toward to a post-pandemic state. In combination with our expectation of rising government bond yields, investors should thus continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from Delta is likely to cause a near-term growth disappointment. On a 12-month time horizon, high single-digit earnings growth coupled with some pressure on multiples continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks. The outperformance of the latter is not dependent on the outperformance of emerging markets, as Chart I-22 highlights that DM ex-US equities now trade at close to a 30% discount relative to their US counterparts – an extreme reading that partially reflects the extraordinary discount of global value versus growth stocks (panel 2). The trend in value versus growth is strongly correlated with the trend in financials versus broadly-defined technology stocks, and rising long-maturity bond yields favor the earnings of the former and weigh on the multiples of latter. Chart I-23 highlights that global small cap stocks may also outperform over the coming year, given their fairly strong correlation with long-maturity bond yields since the start of the pandemic. Finally, as we have noted in previous reports, the US dollar is a reliably counter-cyclical currency over 12-month periods. The recent bounce in the US dollar in the face of rising stock prices has deviated from this relationship, but only modestly so (Chart I-24). A similar deviation occurred in Q1 of this year, and was resolved with the dollar, not stock prices, moving lower. Consequently, we recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Chart I-23Small Cap Stocks Will Likely Outperform If Long-Maturity Bond Yields Rise Chart I-24A Pro-Risk Investment Stance Argues For A Dollar Downtrend   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 26, 2021 Next Report: September 30, 2021 II. The Return To Maximum Employment: It May Be Faster Than You Think When defining maximum employment, many investors focus on the state of the labor market that prevailed as of February 2020. However, the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic, suggesting that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%. This assumes that the Fed deems the ongoing recovery in the labor market to be “broad-based and inclusive,” given revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August. The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects already have or are likely to be reversed as the overall unemployment rate continues to fall. A permanent decline in the participation rate, relative to pre-pandemic levels, is likely given ongoing demographic trends. Even if the recent behavioral impact of retirements is overdone, the demographic impact of retirement on the participation rate suggests that the Federal Reserve may hit its maximum employment objective by next summer, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. In a 2H 2022 rate hike scenario, the fair value of the 10-year Treasury yield will be 2.2%-2.3% next year, which the market is not priced for. This underscores that investors should maintain a short duration position within a fixed-income portfolio, and that equity investors should favor value over growth stocks on a 12-month time horizon. The cyclical outlook for monetary policy in the US rests heavily, if not exclusively, on the length of time needed to return to maximum employment. In this report, we argue that a complete return to the state of the labor market as of February 2020 is probably not required for the Fed’s maximum employment objective to be met, because the jobs market was likely beyond maximum employment at that time. In addition, we highlight that the broad-based and inclusive nature of the Fed's maximum employment objective is objective will not delay the first Fed rate hike beyond what the trajectory of the unemployment rate would suggest, as the odds of a persistent negative impact on demographic segments of the labor market no longer seem meaningful. In fact, the one partial exception that we can identify – retirement – argues for an earlier return to maximum employment. We conclude by noting that a first Fed rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19 or if the Fed’s inflation liftoff criteria are no longer met. Normalized levels of inflation expectations, as well as reasonable estimates of a closed output gap over the coming year, suggest that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. A 2022 rate hike is not currently reflected in market pricing, underscoring that investors should remain short duration within a fixed-income portfolio. Equity investors should expect a meaningful rise in stock market volatility as long-maturity yields rise over the coming year, and should favor value over growth stocks once fears of the likely impact of the Delta variant on near-term economic growth abate. Defining “Maximum Employment” Chart II-1Last Cycle, Rates Began To Rise Before Maximum Employment Was Reached Last September, the Fed’s official shift to an average inflation targeting regime represented a significant break from how the Fed conducted monetary policy in the past. The shift replaced what was previously a “symmetric” 2% inflation target with the goal of achieving inflation that averages 2% over time, meaning that monetary policy is no longer strictly forward-looking. According to the Fed's previous framework, monetary policy should start to tighten before the economy reaches its full employment level, in anticipation that further declines in the unemployment rate will likely lead to accelerating inflation. For example, during the last economic cycle, the Fed began to raise interest rates in December 2015, when the unemployment rate stood at 5% (Chart II-1). But the Fed's new regime implies that the onset of tightening should begin later, the criteria for which was explicitly laid out in the September 2020 FOMC statement: “The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” In addition, while the Fed’s statutory mandate from Congress has always included the pursuit of maximum employment as an objective of monetary policy, revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August explicitly noted that the maximum level of employment is a “broad-based and inclusive goal.” This has left many investors questioning when the Fed’s maximum employment criterion will be reached, with some market participants believing that a complete return to the state of the labor market that prevailed as of February 2020 will be required before the Fed lifts interest rates. But there are three arguments suggesting that the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic: 1. Chart II-2 highlights that the February 2020 unemployment rate ranked at the 5th percentile of its post-WWII history, and was at its lowest level since the late-1960s. While it is true that the unemployment rate would have been higher for most of the last economic expansion based on December 2007 age-adjusted participation rates, Chart II-3 highlights that this effect had waned by the end of 2019. This underscores that the pre-pandemic unemployment rate likely reflected very low labor market slack. Chart II-2The US Labor Market Was Likely Beyond Maximum Employment Levels Prior To The Pandemic 2. The February 2020 unemployment rate stood at 3.5%, which is at the very low end of the Fed’s NAIRU estimates, and meaningfully below the CBO’S long- and short-term NAIRU projections (Chart II-4). Given that NAIRU estimates signify the level of unemployment that is consistent with a steady inflation rate, this implies that 3.5% is likely below the “maximum employment” unemployment rate. Chart II-3The Part Rate Had Mostly Normalized Just Prior To COVID-19 Chart II-4A 3.5% Unemployment Rate Is Likely Below NAIRU Chart II-5Wage Growth Accelerated In Response To A Sub-4% Unemployment Rate 3. The pre-pandemic trend in wage growth also supports the notion that the labor market was past maximum employment levels at that time. Chart II-5 highlights that average hourly earnings and the Atlanta Fed’s median wage growth tracker were both accelerating in 2018/2019, and Chart II-6 highlights that real average hourly earnings growth of production and nonsupervisory employees was close to its 90th percentile historically at the end of 2019. This underscores that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%, assuming that the ongoing recovery in the labor market is deemed by the Fed to be “broad-based and inclusive.”   Chart II-6Real Average Hourly Earnings Growth Was At Its 90th Percentile Historically Prior To COVID-19 Breadth, Inclusivity, And Participation Chart II-7The "She-cession" Is Over The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects have already reversed or are likely to as the overall unemployment rate continues to fall. And as we highlight below, the one partial exception that we can identify – retirement – in fact argues for an earlier return to maximum employment. We focus our demographic segment analysis on four main categories: 1. employment by gender; 2. race; 3. wage level and education; and 4. the impact on labor force participation from retirement. Gender Chart II-7 highlights the impact of the pandemic on the US labor market by gender. In 2020, the impact of the pandemic fell disproportionately on women. The unemployment rate rose close to 13 percentage points for women from February to April of last year, versus a 10 percentage point rise for men. In addition, the recovery in the participation rate last year was less robust for women, who disproportionately cited family responsibilities as the basis for not participating in the labor force. However, Chart II-7 also highlights that the disproportionate labor market impact of the pandemic on women is now over, with the female unemployment rate closer to its pre-pandemic level than for men, with a similar recovery in the participation rate. The difference in wage growth, relative to February 2020 levels, is also now smaller for women than for men. Thus, barring the development of a new divergence over the coming year, there is no longer any basis for the Federal Reserve to distinguish between men and women in the labor market recovery. Chart II-8Black Unemployment And Labor Force Participation Has Mostly Normalized Race Chart II-8 highlights the impact of the pandemic on the US labor market by race. In this case, it is clear that a disproportionately negative effect on Black employment persisted for longer than it did for women. But it is also clear that the Black unemployment rate is now roughly the same magnitude above its February 2020 level as is the case for the overall unemployment rate. In June, the Black labor force participation rate had actually recovered more than the overall participation rate, although it did decline meaningfully in July. The Black labor force participation rate has shown itself to be highly volatile since the onset of the pandemic, and we doubt that the July reading marks a decoupling from the overall participation rate. It is also true that median non-white wage growth has decelerated significantly more than median white wage growth during the pandemic, but this has occurred from a very elevated starting point. Median non-white wage growth was growing a full percentage point above median white wage growth just prior to the pandemic, compared with a half a percentage point below today. This deceleration has likely occurred as a lagged impact from the larger rise in Black unemployment noted above, which has now dissipated – suggesting that nonwhite wage growth is not likely to meaningfully lag over the coming year. Two additional points highlight that Black unemployment, labor force participation, and wages are likely to be highly correlated with overall labor market trends over the coming year. First, Chart II-9 highlights that in 2019 Black workers were underrepresented in management / professional and natural resources / construction / maintenance occupations, and overrepresented in service and production / transportation / material moving occupations. Given that services spending remains below its pre-pandemic trend, it is likely that the Black unemployment rate will continue to decline as the gap in leisure and hospitality and other services employment closes further relative to pre-pandemic levels. Chart II-9Black Unemployment Will Fall As Services Spending Recovers Second, Table II-1 highlights that Black survey respondents to the Census Bureau’s Household Pulse Survey located in New York and California are reporting lower and only modestly higher levels, respectively, of lost employment income than is the case for Black workers in the US overall. Given that services employment in these two states, particularly New York, are the most likely to be negatively impacted by persistent “work-from-home” effects, Table II-1 suggests that Black services employment is not likely to lag gains in overall services employment. Wage Level And Education Chart II-10 highlights wage growth for those with a high school diploma or less, for low-skilled workers, and for those in the lowest average wage quartile, and Charts II-11A & II-11B highlight the impact of the pandemic on the unemployment and participation rates by education. Table II-1No Evidence Of A Negative “Work-From- Home” Effect On Black Unemployment Chart II-10Wage Growth By Education And Skill Level Is Largely Unchanged Chart II-11AThe Least Educated Workers Still Need To See More Job Gains… Chart II-11B…But This Will Occur As Services Spending Improves     On the wage front, Chart II-10 makes it clear that there are no major negative differences between those with limited education, limited skills, or limited pay and the overall trend in wage growth relative to pre-pandemic levels. Reflecting a shortage of workers in some services industries, wages for 1st quartile wage earners and low-skilled workers are accelerating, and are poised to reach their highest level since 2008. On the employment and participation front, Charts II-11A & B show that the job market recovery has been less pronounced for high school graduates and those with less than a high school diploma. But, we believe – with high conviction – that this reflects the industry composition of the existing employment gap, which skews heavily towards service and leisure & hospitality. These jobs tend to require less formal education and training, and to offer less pay. Given this, and similar to the case for Black employment, low education employment growth is unlikely to meaningfully diverge from the trend in overall services employment over the coming year. The Impact Of Retirement On Labor Force Participation Chart II-12Most Of The Pandemic Decline In Labor Force Participation Has Occurred Due To Retirement Chart II-12 presents a breakdown of the change in overall labor force participation from Q4 2019 to Q2 2021 by nonparticipation category. The chart is based off the Atlanta Fed’s Labor Force Participation Dynamics dataset, and employs some Bank Credit Analyst estimates to seasonally adjust the impact of some categories in the first half of this year and to align it with the actual change in the published monthly seasonally-adjusted participation rate. The chart underscores that, while family responsibilities and those who are not in the labor force but who want a job (the shadow labor force) have been important contributors to the decline in labor force participation since the onset of the pandemic, retirement has been the single most important factor driving the participation rate lower. This sharp drop in labor force participation from retirement likely reflects the decision of some older workers to bring forward their retirement date by a year or two, although 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.3 But demographic effects are important, and Chart II-13 highlights that the participation rate has fallen at a rate of roughly 30 basis points per year on average since 2008, reflecting the aging of the population. Chart II-13 is consistent with the age-adjusted participation rate that we showed in Chart II-3 above, and underscores that, even though the recent decline in the participation rate due to retirement is overdone, a permanent decline relative to pre-pandemic levels is likely the result of ongoing demographic trends. In our view, the Federal Reserve is unlikely to regard a demographically-driven decline in the overall participation rate as evidence that the labor market recovery has fallen short of the Fed’s maximum employment objective. It is possible that a return of the working age participation rate to its pre-pandemic level will be viewed as a condition for maximum employment, but Chart II-14 highlights that progress on this front is already more advanced. Chart II-13A Full Recovery To The Pre-Pandemic Labor Force Participation Rate Is Unlikely Chart II-14The Working Age Participation Rate Has Recovered More Than The Overall Part Rate   A lower overall participation rate results in a faster decline in the unemployment rate for any given level of employment growth. Given that there are minimal-to-no remaining labor market divergences along other demographic dimensions of the labor market that aren’t simply correlated with the overall unemployment rate, the implication of a permanently lower participation rate is that the Federal Reserve is likely to hit its maximum employment objective earlier than market participants, and the Fed itself, are currently expecting. Timing The Return To Maximum Employment, And The First Fed Rate Hike Table II-2 presents the average monthly nonfarm payroll growth that will be required to reach a 3.8% unemployment rate, a level that Fed Vice Chair Richard Clarida recently affirmed would in his view likely constitute maximum employment.4 The values shown in the table assume the trend participation rate shown in Chart II-13 above, as well as a recent average of monthly population growth. Table II-2The Return To Maximum Employment May Be Faster Than You Think The table highlights that the unemployment rate is likely to fall to 3.8% following the creation of roughly 4.3 million additional jobs. If the monthly change in nonfarm payrolls continues to grow at its average over the past 3 months, this threshold will be met in January 2022 – essentially a full year before the Fed and market participants expect interest rates to begin to rise. Based instead on a simple linear trend of nonfarm payrolls since late last year, the unemployment rate is likely to fall to 3.8% by sometime next summer. As we highlighted above, the Fed has been explicit that its conditions for raising the funds rate are the following: Labor market conditions have reached levels consistent with the Committee's assessments of maximum employment Inflation has risen to 2 percent Inflation is on track to moderately exceed 2 percent for some time. Currently, the second and third conditions for liftoff are present, suggesting that a first rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. We agree that inflation will slow significantly from its current pace over the coming year as pandemic-induced supply-side factors wane, which some investors have noted may put the Fed’s inflation criteria back into play. But we doubt that the Fed will narrowly focus on the year-over-year growth rate in the core PCE deflator – which will be strongly influenced by base effects next year from this year’s comparatively elevated price level – when judging its second and third liftoff criteria. Instead, the Fed is likely to focus on the prevailing “run rate” of inflation that excludes prices experiencing any disinflationary effects of supply-chain normalization. Chart II-15 illustrates one important reason that the Fed’s inflation criteria will remain “checked” over the coming year. The chart shows that the pandemic, especially last year’s fiscal response to it, has “normalized” important measures of inflation expectations (based on an interval of 2004 to today). We noted in a report earlier this year that inflation is determined by both the degree of economic slack and inflation expectations, a framework that the Fed and many economists refer to as the “modern-day Phillips Curve.”5 Chart II-15The Fed’s Inflation Liftoff Criteria Are Likely To Stay “Checked” Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade, but we noted in our report that this perception is due to a singular focus on the economic slack component of the modern-day version of the curve – to the exclusion of inflation expectations – and a failure to consider the lasting impact of sustained periods of a negative output gap on those expectations. Chart II-16A Closed Output Gap Will Support Liftoff-Consistent Inflation Chart II-16 highlights that both market and Fed economic projections imply a positive output gap within the next 12 months, suggesting that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. Declines in the prices of goods that have surged as a result of the disruption of global supply chains could potentially lower inflation expectations over the coming year, but our sense is that this is only likely in a scenario in which the prices of these goods fall below their pre-pandemic levels (which we do not currently expect). Investment Implications      There are three key investment implications of a potentially faster return to maximum employment than is currently anticipated by investors and the Fed. First, Chart II-17 highlights that the market is not priced for a first Fed rate hike by next summer, and Table II-3 highlights that a sizeable majority of respondents to the New York Fed’s Survey of Primary Dealers do not expect a single rate hike in 2022. Chart II-18 highlights that the fair value of the 10-year Treasury yield a year from today is 2.2%-2.3% in a 2H 2022 rate hike scenario, underscoring that a short duration stance is warranted within a fixed-income portfolio over the coming year – barring a long-lasting impact on economic activity from the Delta variant of COVID-19. Chart II-17The Market Is Not Fully Priced For A Quick Return To Maximum Employment Table II-3Market Participant Surveys Show No Hike Expectations Next Year Chart II-18Investors Should Maintain A Short-Duration Fixed-Income Stance Second, while a 2.2%-2.3% 10-year Treasury yield would not necessarily be negative for stock prices on a sustained basis, Chart II-19 shows that it would bring the equity risk premium (ERP) within its 2002-2007 range. The level of the 10-year yield that is consistent with that range has fallen relative to pre-pandemic levels and is now clearly below the trend rate of economic growth, due to a significant run-up in equity market multiples. This underscores that stocks are the most dependent on T.I.N.A., “There Is No Alternative,” than at any other point since the global financial crisis. It is unclear what ERP investors will require to contend with the myriad risks to the longer-term economic outlook, many of which are political or geopolitical in nature and which did not exist in the early 2000s. Chart II-19Now, Stocks Are Increasingly Dependent On Low Bond Yields Consequently, there are meaningful odds that equities will experience a “digestion phase” at some point over the coming year as long-maturity bond yields rise – potentially trading flat-to-down in absolute terms for several weeks or months. It is also possible that stocks will experience a more malicious sell-off, if it turns out that equity investors require a structurally higher risk premium than what prevailed prior to the global financial crisis. This is not our base case view. We continue to recommend an overweight stance toward equities in a multi-asset portfolio. But it is a risk that warrants monitoring over the coming year. Finally, rising bond yields clearly favor value over growth stocks on a 12-month time horizon. In the US, the sizeable recent bounce in growth stocks has occurred alongside a renewed decline in the 10-year Treasury yield, which itself has been driven by renewed fears about the economic impact of the Delta variant. Thus, growth stocks may remain well bid relative to value in the very near term. But on a 12-month time horizon, value stocks are likely to outperform their growth peers, as long duration tech sector valuation comes under pressure and financial sector earnings benefit from higher interest rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum. Bottom-up analyst earnings expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. But investors more focused on the near term, we would note the potential for further underperformance of cyclical sectors, value stocks, international equities, and most global ex-US currencies versus the US dollar. The US 10-Year Treasury yield has fallen sharply since mid-March, but may be in the process of bottoming. This decline was initially caused by waning growth momentum, but has since morphed into concern about the impact of the delta variant of SARS-COV-2 and the implications for US monetary policy. 10-year Treasury yields are well below the fair value implied by a late-2022 rate hike scenario, underscoring that the recent decline in long-maturity yields is overdone. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the 3-month rate of change in industrial metals prices is now close to zero. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, will likely weigh on commodity prices at some point over the coming 6-12 months. US and global LEIs remain very elevated, but are starting to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 2 “Herd immunity a ‘mythical’ goal that will never be reached, says Oxford vaccine head”, The Telegraph, August 10, 2021. 3 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. 4 Outlooks, Outcomes, and Prospects for U.S. Monetary Policy, by Fed Vice Chair Richard H. Clarida, At the Peterson Institute for International Economics, Washington, D.C. (via webcast), August 4, 2021 5 Please see The Bank Credit Analyst Special Report "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated 18 December, 2020, available at bca.bcaresearch.com

Highlights US Treasuries: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. The spread of the Delta variant in the US represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe is a positive sign that the US can see a similar result and avoid a major economic hit. Stay below-benchmark on US duration exposure. UK: The Bank of England is starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge is losing momentum. UK Gilt yields are vulnerable to a hawkish repricing with only 48bps of rate hikes discounted by the end of 2024. Stay below-benchmark on UK duration exposure, and downgrade Gilts to underweight in global bond portfolios. A New Turning Point For Global Bond Yields? After seeing steady declines since the peak in late March that took the yield down to an intraday 2021 low of 1.13% last week, the 10-year US Treasury experienced a rebound back to 1.30% in a span of just three days. Yields in typically “high-beta” countries like Canada and Australia also saw significant increases. There were two main triggers for the pickup in US yields. Firstly, a speech from Fed Vice-Chair Richard Clarida was interpreted hawkishly, as he stated that he expects the conditions necessary for the Fed to begin lifting rates would be met by the end of 2022. Secondly, a better-than-expected July employment report confirmed the strength of the US labor market already evident in booming demand indicators like job openings. A third potential cause of the trough in yields can be found outside the US in the increasingly positive news on the spread of the Delta variant coming out of the UK. We would argue that the more relevant turning point for global bond yields in 2021 was not the late March peak in the US, but the mid-May peak in non-US developed market yields. The 10-year UK Gilt yield reached its 2021 apex on May 13, just as the spread of the Delta variant was starting to push UK COVID-19 case numbers sharply higher – despite the high vaccination rate in that country (Chart of the Week). This raised the fears that the “reopening boom” could stall, not only in the UK but other major economies, at a time when global growth momentum was already starting to cool off from the overheated pace in the first half of the year. Chart of the WeekThe "Delta Rally" In Bond Markets Is Fading The Delta variant wave continues to wash over the US, although primarily in regions with lower vaccination rates. There was little sign of any impact from the variant in the July US jobs data with just over one million new jobs added (including revisions to prior months) and the unemployment rate falling one-half of a percentage point to 5.4%, the lowest level since March 2020 (Chart 2). However, we will need to see more economic data from July and August to confirm that this latest wave is not having a material impact on the broad US economy beyond the regions with lower vaccination rates. New COVID-19 cases in the UK peaked in mid-July, and are rolling over in continental Europe, with relatively low hospitalization rates – a hopeful sign that the US Delta spread could also soon begin to lose momentum. We continue to believe that steady improvements in the US labor market will be the driver of higher US bond yields over at least the next 6-12 months, as falling unemployment will embolden the Fed to begin tapering asset purchases and, eventually, begin rate hikes towards the end of 2022. The technical backdrop for Treasuries has become less of a headwind to higher yields, with the 10-year yield falling back to its 200-day moving average and speculators closing a lot of short positioning in Treasury futures (Chart 3). If the US can follow the more positive news from across the Atlantic with regards to the spread of the Delta variant, this would remove another impediment to higher US bond yields. Chart 2Steady Progress Towards The Fed's Employment Goals Bottom Line: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. Chart 3Technical Backdrop Less Of A Headwind To Higher US Yields The surge in Delta variant cases represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe may be a positive sign that the US will avoid a major economic hit. Stay below-benchmark on US duration exposure. A Gilt-Bearish Shift In Tone From The Bank Of England Chart 4Pressures Building On The BoE To Dial Back Stimulus BCA Research’s Global Fixed Income Strategy has had the UK on “downgrade watch” over the past few months. Improving growth momentum and recovering inflation have raised the risks of a more hawkish turn by the Bank of England (BoE), as evidenced by the elevated reading from our UK Central Bank Monitor (Chart 4). At the same time, the spread of the Delta variant injected a note of caution into an otherwise positive UK economic story. We now think it is time to move from “downgrade watch” to a full downgrade of our current neutral stance on UK Gilts. The BoE left its policy settings unchanged at last week’s policy meeting, but did provide strong indications that some removal of monetary accommodation would soon be necessary. The central bank noted that the UK economy was recovering from the pandemic shock at a faster-than-expected pace. In the August Monetary Policy Report (MPR) also released last week, the BoE maintained its 2021 real GDP growth forecast at 7.25% while slightly raising its 2022 growth estimate to 6%. UK GDP is now projected to fully recover to the pre-COVID level by the end of 2021. More importantly, the projections for the unemployment rate were lowered substantially. The central bank no longer expects much of an impact on unemployment when the UK government’s job-protecting furlough scheme expires in September. The BoE now expects unemployment to peak at 5.1% in Q3/2021 (Chart 5), a big change from the 6% projection in the May MPR, with the central bank noting that job vacancies are already back to pre-pandemic levels. The unemployment rate is projected to reach 4.25% in both 2022 and 2023. Chart 5Major Changes To The BoE's Forecasts The BoE baseline forecast now calls for UK headline CPI inflation to see a temporary surge to 4% in Q4/2021 – a significant change from the 2.5% peak in inflation projected in the May MPR - before returning back to close to 2% over the next two years. Yet the minutes of last week’s policy meeting noted that the medium-term risks surrounding inflation were “two-way”, a message that sounds a bit more concerning compared to the benign 2022/23 inflation projections. The BoE is now running the risk of underestimating how long the UK inflation uptrend can persist and force increases in interest rates – perhaps beginning as soon as mid-2022 – given the multiple factors that are pushing up inflation. A modest growth hit from the Delta variant The daily number of new cases has fallen by nearly one-half since the peak on July 20th, according to the Oxford University data (Chart 6). Hospitalizations are also rolling over at a peak that would be one-quarter the size of the January peak. If these trends continue, this latest wave of COVID will not have a lasting negative impact on the economy that would dampen inflation pressures. The modest dip in the UK manufacturing and services PMIs in June and July, when cases were rising, supports this conclusion. Accelerating wage growth UK job vacancies are now higher than the pre-pandemic peak, while the BoE’s Agents’ Survey of companies reports an increasing number of firms reporting recruitment difficulties across a broader range of industries (Chart 7). The job market frictions are similar to the dynamics currently at play in the US, where labor demand is booming but firms have struggled to fill openings because government pandemic support programs have dampened labor market participation. Chart 6The Biggest Threat To The Dovish BoE Stance Chart 7Good Help Is Hard To Find In The UK The BoE noted in the August MPR that its forecasts include the impact of labor market frictions that have temporarily raised the medium-term equilibrium rate of unemployment during the pandemic, resulting in a surge in wage growth. However, this effect is expected to fade as the economy normalizes and government support programs expire. For example, the BoE estimates that the UK government’s job retention “furlough” scheme, which pays a reduced wage to workers who cannot work because of COVID economic restrictions and which expires in September, has acted to dampen measured wage growth over the past year. At the same time, compositional effects, with pandemic job losses being skewed towards lower-paying roles, have had a far greater impact in lifting wage growth. The BoE estimates that the “underlying” pace of wage growth, excluding pandemic effects, is only 3.3% compared to the reported 7.2%, but is expected to rise towards 4.5% in Q3 as the labor market recovers. Yet if the employment frictions do not fade as rapidly as the BoE expects, perhaps due to persistent skills mismatches for existing job openings, then the inflationary pressures emanating from the UK jobs market may cause UK inflation to stay elevated for longer than the BoE is projecting. Continued recovery from the initial COVID shock Chart 8Recovering From The COVID Recession The BoE now expects UK real GDP to return to its pre-pandemic level in Q4 of this year (Chart 8). Much of the recovery in activity seen so far has been in services as pandemic restrictions have been lifted. Looking forward, consumer spending will be boosted by improving growth momentum in employment and incomes, further underpinned by a high levels of household savings accumulated during the pandemic. Business investment is also expected recover, given the robust reading from the BoE Agents’ Survey of investment intentions (bottom panel). The twin engines of consumption and investment will be enough to keep the UK economy growing at an above-trend pace in 2022, even with a modest expected drag from fiscal policy, which should help maintain some of the current cyclical inflationary pressures. Rising house prices UK house prices are experiencing another sharp uptick, with the Nationwide index up 10.3% year-over-year in Q2 (Chart 9). Demand for homes has been boosted by the UK government’s holiday on stamp duty, or housing transaction taxes, which began last year as a form of pandemic economic support. Housing transactions spiked in June as demand surged ahead of the expiry of the stamp duty holiday last month, and some payback is likely in the near-term. Yet UK housing demand has also been supported by the same factors boosting house prices in most developed economies - low interest rates, high household savings available for down payments and the increased need for space for those choosing to work from home. UK house price inflation thus could remain higher for longer than the BoE expects. Chart 9Is This House Price Surge 'Transitory' Or Policy Driven? Supply Chain Bottlenecks The BoE noted in the August MPR that overall UK import prices have risen faster than expected, especially with the British pound higher on a year-over-year basis. UK firms have faced rising input costs because of disruption to global supply chains from the pandemic. For example, the annual growth rate of import prices for manufactured components rose by 12.1% in May, a sharp contrast to the -5.4% deflation of consumer goods prices (Chart 10). The BoE projects UK overall import price inflation to turn negative in 2022 and 2023, a big part of its slowing inflation forecast. Some decrease is inevitable as price momentum in oil and other commodities cools from overheated levels seen in 2021. However, supply chain disruptions are a global phenomenon already persisting for longer than expected in other countries and could linger into 2022 if global growth stays above trend - potentially causing UK import price inflation to once again exceed the BoE’s expectations. Summing it all up, the pressure is clearly building on the BoE to dial back the massive monetary easing put in place last year in response to the pandemic. Not only is the economy now recovering far more rapidly than the BoE had been projecting, with inflation set to peak at a higher level, but there are other indications that monetary conditions may now be too loose like accelerating house prices. There are numerous upside risks to the BoE’s benign post-2021 inflation forecasts, especially with the central bank also projecting the UK to have a positive output gap in 2022 and 2023 (Chart 11). Chart 10BoE Betting On Waning Global Supply Bottlenecks Markets are not expecting much from the BoE in terms of interest rate increases. While the UK overnight index swap (OIS) curve is now discounting an initial 25bp rate hike in August 2022, only one other 25bp increase is expected by the end of 2024 (Table 1). Chart 11Domestic Price Pressures On The Rise The BoE has not been a very active central bank since the 2008 financial crisis, never raising the Bank Rate above 0.75% over that time, thus the markets now seem conditioned to think that the BoE will continue to do very little in the future. Table 1Markets Expect The BoE To Hike Before The Fed Chart 12Markets Expect Persistent Negative UK Real Rates That is evident when you look at longer-dated OIS rates compared to forward inflation rates from the UK CPI swap curve. The combined message from those markets is that the BoE is expected to maintain deeply negative real interest rates for at least the next decade, a major reason why the UK has persistently negative real bond yields (Chart 12). A lower equilibrium real interest rate (i.e. “r-star”) is consistent with the declining trend in the OECD’s estimate of UK potential real GDP growth over the past 20 years (Chart 13). Yet it is a stretch to think that the neutral UK real interest rate is now negative, especially given how rapidly UK growth and inflation have snapped back from the 2020 COVID recession. UK interest rate markets are highly vulnerable to any hawkish shift by the BoE – and outcome that the current growth and inflation dynamics suggest is increasingly likely over the next 6-12 months. The BoE has already started to process of dialing back monetary accommodation by slowing the pace of asset purchases in its quantitative easing (QE) program (Chart 14). While no decision on additional tapering was made last week, the BoE did dedicate three pages of the August MPR to a detailed discussion on how the future size of the BoE’s balance sheet would likely be reduced if the BoE were to begin raising interest rates. There has also been some political pressure on the UK to dial back QE, with the Chair of the Economic Affairs Committee in the UK House of Lords saying that the BoE was “addicted” to QE last month. BoE Governor Andrew Bailey has previously stated that he viewed QE as a regular part of a central banker’s toolkit, to be used opportunistically during periods of deep economic or financial market stress. That made sense in 2020 during the height of the pandemic, but is no longer the case now. Chart 13UK R-Star Is Still Positive We anticipate that the BoE will end the current QE program sometime in the next six months, with an initial 25bp rate hike occurring sometime in mid-2022. Chart 14UK QE: Expect More Tapering This would be a faster pace of tapering, with a quicker liftoff, than the Fed, although we expect the Fed to eventually raise rates by more than the BoE in the next interest rate cycle. Investment Conclusions Given our expectation that the BoE is starting to prepare the markets for an unwind of its pandemic policy settings, we come to the following fixed income and currency investment conclusions (Chart 15): Chart 15Summarizing Our UK Fixed Income Recommendations Chart 16A More Hawkish BoE Would Benefit The Pound Duration: Maintain a below-benchmark duration stance within dedicated UK bond portfolios, with too few rate hikes discounted Country Allocation: Downgrade UK Gilts to underweight in global bond portfolios Yield Curve: On a tactical (0-6 months) basis, the UK Gilt curve may re-steepen as UK and global growth stays resilient, but a more hawkish BoE will eventually result in a flatter Gilt curve Inflation-Linked: Inflation breakevens on UK index-linked Gilts are already quite elevated and are overvalued on our fair value models, while real yields are at deeply negative levels that are conditioned on a continually dovish BoE – a combination that suggests an underweight stance on UK linkers is appropriate. Corporate Credit: Stay neutral on a tactical basis, as solid UK growth will offset the impact of a shift to a less dovish BoE. Currency: Our currency strategists are positive on the British pound - which is undervalued on their models (Chart 16) - over the medium-term, with the BoE seemingly on a path to begin tightening monetary policy sooner than the ECB and perhaps even the Fed.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns