09/18/2020

Juggernaut
Part 3 of our Reflation Series

"We believe the trade of a lifetime is found in a growing tug of war across markets.
Investors are focused on obvious deflation risk, but the side effects of the $15 Trillion of
fiscal and monetary spending globally are underappreciated. Everybody knows the
COVID-19 tragedy poses a significant deflation risk – the signs are on every street
corner. In our view, the “unexpected” we must be positioned for is Trillions in fiscal
stimulus oozing into the economy after this virus has been snuffed out. This is a sector
left for dead to the point where it is now an after-thought. We see last week's
outperformance of the XME Metals & Materials ETF as the first heartbeat of a Phoenix
coming back to life, the GENESIS of a significant leg higher. Keep in mind, we don’t
even need real inflation for commodities to shine looking forward. The consensus is so
skewed to further deflation that even the slightest change in expectations will lead to
meaningful outperformance from commodity-sensitive risk assets relative to the S&P
500."

Bear Traps Report, March 29, 2020

Chapter 1, See our late-March commodities thesis here.

Our High-Conviction Longs with a 12-18 Months View

ECH Chile ETF

EWZ Brazil ETF
GDX Gold Miners ETF
MOS Mosaic
SLV Silver Trust
STLD Steel Dynamics
TECK Teck Resources
XLE Energy ETF
XME Metals and Mining ETF
XOM Exxon Mobil
VLO Valero Energy

This reflation basket was established in April, however, recent moves in some of these
equities have pushed RSI (relative strength index, momentum) to very high levels. We
certainly expect a near-term pullback in names like Teck Resources and Mosaic but we

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

look to add into weakness with a bullish long-term view. For clients that are already
long, selling upside covered-calls on some of these positions makes sense, in our view.

High-Conviction Short-term Trades (3 Month view)

Short QQQ Nasdaq

Short AAPL Apple Inc.*
Short SOX Semiconductor**

*Initiated September 1st

**Initiated September 15th

The Fed Sending a Message

We believe the most important takeaway from this week's FOMC meeting comes down
to Chairman Powell feebly attempting to parse between QE and forward rates guidance.
On Wednesday, the Fed gave "powerful forward guidance" of zero rate hikes for as far
as the eye can see, but was unable to provide any forward guidance on asset
purchases - Powell refused to answer the question twice in the press conference. With
conviction, we believe this is significant and the probability of a Nasdaq crash has risen
meaningfully.

In our view, Chair Powell is sending Congress and SoftBank a very clear message. The
last thing the FOMC wants right now? To get back into a "2010-2016" like-situation
where politicians keep piling all the heavy lifting on central banks. Now, that would be
deflationary (Sequestration, Tea Party)! The second last thing the FOMC wants right
now is excessive speculation in the Nasdaq - if it pops like the dot-com bubble, it would
require even more help from the Fed. They want to let some air out of the balloon,
without disrupting financial conditions on Main St.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Financial Conditions are the Key to Determining the Location of the Fed Put

If FCIs tighten meaningfully, look for the Fed to give the serpent inside the market what
it wants, more certainty on their balance sheet expansion plans. In other words, only
more financial market stress will reverse the Fed's current course. Powell was asked
twice this week for certainty on the Fed's balance sheet agenda, he would NOT
acquiesce. We MUST remember how FAST the Fed can turn on the investment
community. Sure, a five-year-old can tell you $120B a month is an awful lot of
accommodation. The MOST IMPORTANT question, is it certain for three months, 12
months, or two years? Not only did the Fed NOT answer the question, but Powell left
the door open for LESS balance sheet accommodation. This ladies and gentleman, is
the sword thrusted into the side of the beast that is the Nasdaq. A ferocious bull is
wounded.

Smart Investors Don't Trust Rug Pullers

On December 16, 2018, our central bankers were pounding the table, promising us $1T
of balance sheet reduction and six more rate hikes as far as the eye can see.
Three weeks later, they opened the door to ending the balance sheet "normalization"
process and killed off any notion of rate hikes. The really smart money in big tech
knows this. On Wednesday, when chair Powell didn't offer investors certainty on the
balance sheet expansion policy path, it was a shot across the bow. See our CNBC
segment here, for a quick explanation. The bottom line, for big tech to command today's
lofty valuations, balance sheet expansion certainty is needed from the Fed. We have
been making this point with conviction in recent weeks.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Nasdaq, Worst September Since Q4 2018

A lot of pain has been inflected, the bulls will try and buy the dips into quarter-end,
September 30th. We see a crash by October 10th, sell EVERY rally.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Total Copper Pounds used in Electric Vehicles

Car: 31 hybrid electric vehicles (HEV): 82

Plug-in hybrid electric vehicles (PHEV): 131
Battery electric vehicles (BEVs): 186

Bloomberg, Bear Traps Report

The XME Metals - Mining is Sending us a Message

Most people forget how much Copper and Cobalt is used in electric vehicle production.
The mad mob is too busy piling into Tesla TSLA stock without doing the math behind
the materials and commodities which will be needed to support this EV revolution. In our
view, looking out 5-7 years there is a large disconnect between rosy electric vehicle
sales forecasts and the commodity infrastructure needed to fuel this much talked-up
run. Next, think about the $3T of capex reductions which came out of the commodity
space in recent years and left us with dramatically LESS of a supply threat. This
crucial fact dramatically improves the risk/reward in the commodity and resource
space looking out over the next 3 years. China, which has been leading the global
economic recovery for months now, published data this week that showed industrial
output growth accelerated to 5.6% YoY in August. This strengthens our view that
Beijing’s demand recovery continues to gather pace, with government stimulus helping
to fuel a rebound. Clearly, we’ve already seen a metals-intensive response in China.
The risk-reward setup is very attractive looking out to 2021-2023. ETFs in the metals /
materials space include; XME, PICK, DBB, and CPER.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Commodities - An Empty Meadow in April, Now has more Interest from the
Patrons

“I’m watching things like iron ore very closely now because those sorts of industrial
commodities are going to skyrocket if we do get this bounce-back driven by
infrastructure and then that will filter into oil,”

Andy Critchlow, EMEA at S&P Global Platts

Looking Forward Politically we see Two Primary Potential Outcomes

1. In Washington, as Congress delivers the next fiscal care package, hand in hand with
a vaccine cocktail coming to market in the months ahead, it will be a reflation investors
delight. These two engines will be the trade's rocket fuel, propelling the investment
thesis from the early to "middle innings." Months from now, Powell may look very wise
in NOT offering up "certainty in balance sheet accommodation" ahead of Congress and
Vaccines. He kept his powder dry, smart.

2. If Congress fails to deliver this year, the deflation camp has another party. We will
see a 10-20% drawdown in our reflation basket which should be BOUGHT with both
hands. Next, market stress will force the classic policy response out of Capital Hill. This
New Deal on roids will have one anchor tenant. Large scale infrastructure spending will
join us early next year - next, commodities and value crush growth stocks in 2021.

"Despite key negotiators all saying they want to reach a deal on another stimulus
package, we have lowered the chance that a deal will happen this month. Unless they
come back to the table ready to compromise, a deal before November 3rd seems very
unlikely."

ACG Analytics, Washington

============================================================

Juggernaut
Attractive Risk-Reward on Inflation Bets

An overlooked, important point is making some noise today. The policy backstop post-
COVID has dramatically improved the risk/reward dynamics found inside inflation
bets. In prior cycles, we had a deflationary tail-risk of "what if we have a shock". Over
the past 10 years, we became accustomed to low inflation even when the economy was
expanding, so the asymmetric risk was always a "what if" recession and deflation. Fast-
forward to today, we just experienced one of the most deflationary economic events in
the past 100 years with Coronavirus and we STILL don't have deflation-certainty looking
out five years. We had the shock and got through it without deflation - this changes the

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

distribution for prices. Why would you still be overweight deflationary-benefiting assets
such as long-end bonds and technology equities after this? After a decade of
deflationary events, from the European debt crisis to Brexit, to a trade-war, all
culminating in the ultimate economic shock of global COVID lock-downs - there is no
juice left to squeeze out deflation-benefiting assets. Governments around the world
have proven they will do all they can to prevent a left-tail deflationary outcome, this
crushes the risk/reward pay-off of deflation bets in our view.

"The largest profits are achieved by discounting the obvious, and placing capital in the
direction of the unexpected."

George Soros

Tremors before the QUAKE

The story of the month? The growth to value tremors have been revisiting with
intensity, the 'quake' is coming. As long as the RLG Russel Growth vs. RLV Russell
Value ratio stays under 1.85, the long value trade is a home-run. With the certainty of 5-
year deflation in fierce retreat, more and more high-quality names (Druckenmiller,
Einhorn, Melkman, Greenspan, Sherman/Gundlach, and co) are publicly talking-up
inflation risk. The natives are restless, real money asset managers are listening. Capital
is starting to exit growth, nearly $1T last 10 days. In our view, the modern risk-parity
model is about to collapse and is in store for a colossal face-lift (risk parity = long
equities and extra-long bonds).

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

"By the time we actually see inflation, it will be FAR TOO late to protect a bond portfolio,
that we can promise you with passionate certainty. Today, an extra $70T in fixed
income globally sits with less than 1.0% in yield, this comes with a steep price. After a
long decade of austerity, Brexit, trade wars, and Covid19; bond investors have fallen
into a deep sleep. Every extra dollar placed in this ocean of risk changes the formula.
The market's reaction function will join us FAR before inflation actually appears. It's
already happening today. Hence, the latest commodity bid, you don't see 35% one-
month moves in Silver very often. Unless your names are Sonny and Cher."

Bear Traps Report, Convexity Climax, July 28th, 2020

The Building Blocks of Inflation

Extremes cause regime change. Deflation, globalization, debt levels, and wealth/income
inequality are currently metastasizing into an inflation juggernaut. Some of the key
inflation engines are found in a revived local manufacture primacy (re-shoring),
encroaching labor (political) muscle (influence), and expansionary fiscal pre-eminence
at the expense of monetary drivers.

The size of the opportunity and the problem has reached unimaginable proportions. As
central banks prevent the business cycle from functioning, more and more and more
wealth is created. This fortune is running out of safe places to hide. By our calculations,
this summer we touched $10T in technology stocks alone. Combine that with $15T in
U.S. Treasuries, $10T in U.S. corporate bonds, and $14T in mortgage / Muni-related
bonds. That's a near $50T dilemma for extremely crowded risk-parity strategies. This
year as rates near zero, bonds moved from an asset to a liability. We believe
commodities and commodity-sector equities are in a position to be on the receiving end
of a large wave of capital flows. The entire wealth management industry is poorly
positioned for this historic asset migration.

Timing is Everything

Let's be clear. Pocketing the exact moment of a 30-year trend reversal is a bit like
landing an F-16 on a small aircraft carrier. However, we see mounting evidence. Above
all, we MUST manage risk. In recent weeks, we reduced our short dollar, commodity-
value basket by 30%. If we are faced with yet another head-fake as experienced in early
July, we will redeploy capital into any meaningful pullback.

Conventional wisdom says the SoftBank Whale´s influence triggered the Nasdaq nearly
12% reversal in early September. We believe there is a much bigger story at play,
one we will be discussing a decade from now. For most of this year, the market has
been priced for the obvious, NOT the unexpected. Why not? The risk-parity camp has
been in a winning trade for most of the last 30 years. The sad fact is, there is a limited
'Treasury hedge' available to off-set equity market volatility. It was a great run - but it is
now over. This begs the question: What replaces it?

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

September 2020: Outperformance over Nasdaq 100

Resources TECK 40%

Agriculture MOS 19%
Metals, Mining XME 16%
Transports IYT 14%
Russell Value RLV* 8%

*The best month for value over growth since 2000

Value 5% Outperformance of Growth so far This Month

As clients know we are overweight value and commodity-sensitive global cyclicals

relative to growth. We are seeing more and more evidence which leads us to believe
that we have reached a sustainable turn in this rotation. After 11 months straight of
value losing out to growth, Russell 1000 value is on track for its best month vs. Russell
1000 growth since March 2001. We think there is close to $10T in growth/tech stocks
(as of 14 days ago), too many sheep in the same trade relative to cobra effect type risk,
weak hands are getting shaken out. Which means possibly $2T to $3T needs a new
home, in inflation resistant equities. You can't have Druck, Einhorn, Melkman,
Greenspan, Sherman - Gundlach, and co (quality thought leadership) all talking up
inflation risk 2020-2022 - without real money waking up from a deep sleep. That is what
is happening this week.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

"Two roads diverged in a wood, and I took the one less traveled by, And that has made
all the difference."

Robert Frost

Two Roads

1. Deflation Equity Bets: Growth equities, longer duration; richer valuations with low
and declining rates. This is where the mad mob is having breakfast, lunch, dinner, and
happy hour.

2. Inflation Equity Bets: Materials and resource sectors, value stocks - assets with
lower duration (compared to growth equities); cheaper valuations and will respond well
to any inflationary stock. This is the road less traveled.

Deflation Bets: Bonds and Tech

Over the past decade, the technology equity sector outperformance vs. cyclical small
caps (QQQ/IWM) has closely tracked rising Treasury prices. This shows the Nasdaq
and big-tech equities are a colossal deflation bet. Most equity investors DO NOT
realize this, warning. As inflation, nominal GDP, and interest rates have fallen,
investors have fled cyclical assets and piled into bonds and tech. With technology
equities being the largest weightings in the U.S. equity indexes it has been one of the
great decades ever for risk-parity strategies. Moving forward, we believe this trade is
dead. We are coming out of the most deflationary economic event in our lifetime - the
risk/reward of staying long tech and long-end bonds is atrocious.
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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Deflation to Inflation

Historically, oftentimes deflation forces governments to create inflation. And it forces this
necessarily. Therefore, negative rates are symptomatic of a crisis that forces the
government to create inflation in the most direct way possible: helicopter money.

But that didn't happen in Germany, one may object. Response: are you saying you
honestly believe the USA is like Germany? If you have negative demographic growth
rates in an economy of savers, by a government that hates debt given its memory of
pain from the inflation of the Weimar Republic, then sure, helicopter money is not the
response. Keep in mind, Germany can import money over the short run through its
profits from exporting to the rest of the EU. The U.S. has neither negative
demographics, nor a populace of habitual savers, nor a collective memory of anything
much less the inflation of the late 1970s/early 1980s, nor a trade surplus.

MOS Mosaic and the CRB Food Index

The fiscal spending overdose is doing a lot more for commodities than central bank
policy moves. Equities like MOS closely follow rising prices in the agricultural space. In
the first week of August, the $6 billion MOS reported in their Q2 earnings was the
catalyst for the recent move higher. The company forecasted strong fertilizer demand as
massive floods in China present a robust phosphate demand outlook over the next 12
months. In July, we featured Mosaic MOS three times as a high conviction buy. Reach
out to [email protected] for the in-depth breakdown.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

The Turn has Arrived

In a 5% inflation world, U.S. Treasury rates may snap back nominally but rest below
core inflation levels. A thirty-year trend reversal could take some time, or it could arise
cataclysmically. All our current indicators point to the latter. A variable such as a major
war, for instance, could well compress the transition timeline. Real assets will win, while
surreal valuations will lose.

Historically, inflationary periods are more common and long-lasting than deflationary
ones. Equilibrium regimes are also more common than deflationary ones. Thus, the
least likely scenario over the next 40 years is continuous deflation, from the
historical perspective.

What Actually Causes Inflation?

There is no real consensus as to what causes inflation. This embarrassing fact is an

open secret. Could the cause simply be related to impactful change in the supply and
velocity of money? Imbalances between population growth and supply of goods? Labor
pricing power? Changes in supply and demand? Crop failures? Environmental
destruction? Or is each period of inflation unique, impossible to predict, and only
analyzable in retrospect? Sometimes extreme conditions jump to the fore such that they
cannot be ignored. And such a time is now. We are in the early stages of a money flood
with a massive increase in M1, M2, & M3. If we look at M1 above, it took 19 years to
move from $1.0 to $2.0T. We just surged from $4.0T to $5.4T in eight months. CPI is up
6.3% annualized over the past three months, the highest rate since 2008. Core CPI,
which excludes food and energy prices is up 5.1%, the highest since 1991. Core
commodities are up 8.1%, the highest since 1982.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Fed's Kashkari says warnings of uncontrollable inflation are just 'ghost stories'

This is the ULTIMATE buy signal! "Beware of the Banker who feels the need to attempt
to put you at ease." J.P. Morgan

A Steeper Curve, NOT Listening to Deflation Risk

As U.S. populism continues to lean left towards deficit spending, we must expect this
type of solution in the coming years. Large bond investors know this, which explains
why the 5s - 30s yield curve spread continues to steepen.

UBI is Here to Stay

Breaking news, if you place capital in a person’s bank account, they will spend it. If cash
is appreciating in value to an extreme, the Fed's response will be to depreciate the
value of cash. If banks make fewer loans because cash is being drained away from
them, then there is only one other source of cash creation: the Federal government.
Under a negative nominal rate environment, there is only one recourse available:
helicopter money. In other words, Fed asset purchases funding UBI, universal basic
income or simply depositing cash into U.S. bank accounts. This is essentially happening
now and was clearly the response to March's great deflation threat. By putting cash
directly into people's pockets, those who spend first will reap the greatest economic
reward. It is key that this money goes to those who have to spend: the bottom 50%,
again, they DON'T buy back stock. Once you have more cash chasing the same
amount of goods by those who have no choice but to spend, an inflation juggernaut is
the result.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Velocity vs. Saving in a Pandemic

As a result of the harsh economic effects of the pandemic lockdowns, velocity has
collapsed. A portfolio of vaccines will reverse this trend very quickly. We want to skate
to where the puck is going, NOT where it's been, Gretsky is famous for saying this.
Keep in mind, universal basic income is now in the hands of nearly 10% of all
Americans. When including Pandemic Unemployment Assistance PUA, more than 32.1
million Americans are currently receiving some form of unemployment benefits. Another
45 million Americans are on the Supplemental Nutrition Assistance Program (SNAP).
Unlike corporations who buy stock with tax cuts, when you provide lower-income family
capital, they spend it. Sure, the savings rate has surged, but it is coming down fast (see
above) as the economy re-opens.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Velocity and Inflation

The key reason inflation is tame - no material velocity uptick, but velocity is backward-
looking at the pandemic, once velocity moves, wake up call. Yes, low velocity leads to
inflation in the very near-term, but we believe this is well known and is priced-into global
financial assets. As George Soros said, we must discount the obvious and position for
the unexpected. What is not consensus and what investors are not positioned for is a
sharp rebound in velocity that pulls CPI inflation higher.

The Need for Inflation Hedges

What is the hypothetical policy response to a "right tail" (inflationary) outcome in 2021?
Let’s say there is an effective and widely distributed vaccine in Q1 next year, pent up
demand is met with the combination of supply shocks and pricing power, how does
policy respond? Central banks are going to be trapped when inflation arrives. Their job
is to fight inflation, yet global debt levels are at record highs so they don't want to tighten
policy. This speaks to central banks letting inflation run hot and the need for inflation
hedges.

"Why Commodities?: When a sector has been through a multi-year capitulation process
(Brexit, Trade War, COVID19), followed by a deep - widely held, long in the tooth
consensus view (U.S. dollar shortage, deflation as far as the eye can see) - this is a
recipe for a spectacular risk/reward investment thesis. First, there's nobody left to sell -
and second; most buyers have run for the hills. The recipe. We believe an epic capex
plunge in the global commodity production ecosystem deserves attention (capital

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

investment or dollars in search of hard commodities is off 25-35% in the 2014-2020

period). When a capex collapse triggers colossal supply constraints - right in front of the
developed market's largest fiscal policy expansion (COVID19 Response) in the last 20
years, please pass the nitroglycerin. In our view, this selection of ingredients will
produce a spectacular rebalancing between real assets and financial asset
performance, with the former playing catch up (mean reversion)."

Bear Traps Report, Lessons From Omaha, April 8th, 2020

Commodity Super-Cycle

With inflationary pressures on the rise, we must realize the asymmetric pay-off in being
long commodities. Relative to equities they are at multi-decade lows. Commodities
cycles are historically much longer than the business or credit cycle, in our view, we are
at the bottom of a generational super-cycle.

Inequality and the Death of Risk-Parity

This country is actually not the most divided it has ever been (cf. the Civil War). In fact,
a key unifying factor is well established: both the left and the right hate inequality of
income and wealth. The far left, which is most of the left, and the far right, which is most
of the right, completely agree that rich people are hurting the common laborer. But if you

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

translate that view into economic terms, that is equivalent to saying that the left and the
right hate monetarism, hate disinflation, hate the victory of capital over labor, and hate
the flat Phillips Curve. And now that monetarist theory and its child the risk-parity trade
have both reached or nearly reached their practical limits, what change could possibly
arrive but the ascent of labor and its child, inflation?

But that in turn means pension plans, heavily long the risk-parity trade, lose money, fail
to meet obligations to retirees, and simply fail outright. Save for a few hedge funds that
run concentrated positions in order to capture alpha, the vast majority of invested wealth
is in one version or another of the risk-parity trade. Different practitioners may quibble
about the correct ratio, 60/40 or 55/35 etc., but it is all generically the same. That
game's effectiveness is now over. Beyond financial advisory/management and pension
plans, all based on risk-parity, we have retirement accounts which, theoretically, are
invested for "the long term", a euphemism for risk-parity. That won't be pretty. How will
entitlements/social security be funded if not with inflated dollars? Under a labor regime
as wages go up so will contributions to social security increase, only to be repaid with
depreciated currency. Instead of stocks and bonds both on average gaining as they
have over the past 40 years, they will now both decline. Because of leverage in the
system, the retracement may well take less time than the prior advance. Ten years from
now we could well have 10% treasury yields on the long end, with an S&P P/E ratio of
10.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Bloomberg Dollar Index is a Global Growth Multiplier on the Way Down

The market is entertaining a pretty striking inconsistency. Cyclical risk assets like
Maersk's equity (world's largest shipper) are enjoying the weaker U.S. Dollar, yet long-
end interest rates have yet to budge higher. If you just look at the transportation sector
one would think we are pricing an 85 or 80 DXY Dollar Index world (currently 93 down
from 103 March peak) where nominal GDP is still dead, so rates remain low and tech
continues to outperform everything else. Given how big of a multiplier a weaker U.S.
dollar is on the global economic cycle, this cannot be true, just look at Maersk. Time
after time, dollar weakness has led to meaningful counter-trend rallies. Every time the
dollar weakness was NOT sustained, the stock price collapsed. Bottom line, cyclical
assets can't keep ripping at this pace without 30 year Treasuries moving sharply higher
in yields.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

XLF Financials vs. Dow Transportation Equities

After moving in lock-step for over a year, the Dow Transports Index completely diverged
from the financials sector at the beginning of July. While transports are now above their
February 2020 highs, the XLF Financials ETF is still below best levels from early June.
This is financial repression visualized. Even with rising economic expectations over the
past few months, the Federal Reserve has pointed at keeping the long-end of the yield
curve as low as possible, hurting bank profitability. Keep in mind, the divergence began
in July right when Brainard and other FOMC members began to table yield-curve-
control. The question moving forward - will the market continue to believe the Fed can
keep the long-end under control?

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Dollar Weakness Driving Inflation Expectations

What if the dollar goes into a Q3 2017-like plunge? That's a game-changer for the
global economy and changes the growth/inflation dynamic going forward. Let's be clear,
ten-year breakevens will not be 1.80% in an 80 DXY world. The big question now is,
has the reflation trade up to this point been pricing inflationary pressures or just the
removal of deflationary risks? We clearly side with the former. In theory, we could define
the move in breakevens as simply mean reversion. Take what’s priced in on inflation
swaps, the composition of the move is that inflation will *certainly be above 1%, but very
little of the move is in the possibility that inflation will be significantly above 2%. Bottom
line, there's miles left to run in the reflation trade, but let’s be real, the probability of a
deflation scare is still fairly significant.

With this in Mind, We Enter 3 Possible Camps for the Market and Inflation:

1) The Current Camp: Deflation is off the table, but this will still be a slow recovery, so
long-dated Eurodollar futures stay flat just like the Fed's dots. In this world, risk assets
get benefit of mean reverting economic data and zero discount rates forever.
Meanwhile, duration acts as a vacuum for equity risk premium and the long tech vs.
'everything else' trade continues to work despite technical hiccups. This scenario would
be a continuation of the past decade.

2) The Second Potential Camp: Fiscal inaction leads to a deflation spiral and markets
challenge the idea of a fiscal-put and successful policy hand-off from from the Fed to
Congress. As Coeure (ECB) always warned us, fiscal policy lacks "agility". In this world,

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

shorter term liquidity concerns turn into longer term solvency once again and risk-
premium shoots up. This risk has been largely put down in places like Europe, as
Germany has extended their furlough scheme until the end of 2021. However, it’s hard
to say in the U.S. it is off the table. This scenario would be another version March 2020.

3) The third camp, the new world of fiscal is here. Aggressive fiscal policy leads markets
down a much swifter recovery path, and we begin to question what if neutral rates won’t
be 0 forever. This is the world where fiscal transitions from an economic backstop to an
economic accelerant. This world is becoming easier to imagine. It is perfectly in the
realm of possibilities that the U.S. has an effective and widely available vaccine in Q1
2021 into a new democratic mandate that passes a +$3T HEROs bill.

It is very possible that both tails are underpriced at the moment. The market is fully
priced under the assumption that fiscal/monetary will be big enough to to cap any
downside risks but not too big to create inflationary pressures. While that is the most
likely outcome, it is a very tight distribution for a policy set that we really don't know
much about.

Copper Wedge

Copper may be evidence of the third camp is gaining steam. After a failed-breakdown
from the long-term support trend in March, copper has since ripped higher breaking out
of the long-term wedge to the upside. Remember, from a technical point of view, failed-
breakdowns lead to even faster breakouts.

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 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Inflation Drivers

To us, it is clear - over the last decade moving from Tea Party - Sequestration to MMT,
fiscal support has changed the calculus for hysteresis in the next cycle. As in, we have
far less of it. It is no mere coincidence that during times of economic distress, socialism
and communism become hotly debated. Instead of laughing about it, over 30% of
people below the age of 40 believe socialism is better than capitalism, while only a
minority of those can correctly define the terms. At a minimum, this speaks to a push for
greater power for labor and less power for capital.

A shift from just in time global supply chain to increased domestic manufacture as a
counterpoise to China's Belt and Road policy is a safe forecast. This will cause a huge
demand for labor. The Phillips Curve won't remain flat under that scenario. The younger
generations as a rule are sensitized to environmental concerns. As the USA and Europe
become more green, associated costs will cause extra price pressure. In sum, inflation
is a quite complex phenomenon, and thus is unlikely to have a simple, obvious cause.
This explains why academia has failed to arrive at a nice, neat simple explanatory
model for inflation.

Right now we have massive money creation, massive fiscal stimulus, and strong social
forces combining to create an inflation juggernaut. Stocks and bonds will both enter a
secular bear market, debt as a percentage of GDP will continue to climb, nominal tax
rates on the rich will increase, Central Banks will remain accommodative at least for the
medium term, and money supply will continue to expand. Most important of all, wages
will go higher. The risk-parity trade is dead. Over the next twelve months we will bury it
and read its last rites.

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 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Rio Tinto Breakout

Rio Tinto, one of the world's largest miners is breaking out above a resistance zone
which has served as a ceiling for the stock since 2011. There is also a massive reverse
head and shoulders that has formed in the past decade. This stock is a must buy into a
breakout, in our view.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Election Outcomes: Assuming Democrats Take the House

Rep Senate + Trump = Infrastructure

Dem Senate + Trump = Infrastructure/social spending
Dem Senate + Biden = UBI/debt forgiveness
Rep Senate + Biden = Least likely heavy-spending scenario, tail-risk to the reflation
trade

Election 2020

This year's election will have massive implications for the probability and 'type' of
inflationary pressures we see in the years to come. With a Trump presidency (and either
party in Senate), we believe fiscal spending will be much more pro-growth such as a
large infrastructure bill. Meanwhile, if the Dems sweep, fiscal spending will come, but in
a much different form. A Democratic Senate combined with a Biden Presidency is likely
to; keep unemployment insurance high, spend on social issues such inequality and
green-energy, and include debt forgiveness. Just this week, Senator Schumer and
Senator Warren dropped a resolution calling for executive action on federal student loan
debt, up to $50k cancelled by proclamation! Keep in mind, 'debt jubilees' like this are
highly inflationary. One tail-risk we see is a Republican Senate victory with a Biden
Presidency. This would be the most deflationary outcome. Trump has pushed
Republicans like Mitch McConnell to spend more since his election in 2016, with no
Trump in office, Republicans are much more likely to put up a fight on fiscal spending
during a time of a record budget deficit.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

The Fed's Push for Inflation

The main reason the Fed wants inflation? It is the ultimate punishment for money
hoarding, forcing people who have cash to make loans and investments. However,
excessive inflation makes investing difficult as well. Hence, the Fed's preference for low,
steady inflation. This means, directly, in an economy with an expanding money supply
coupled with a decreasing velocity of money, people and institutions are hoarding
money, which is a disinflationary accumulation of capital. Such was the period after the
Great Recession.

Jeff Bezos famously quipped: "Your gross margin is my opportunity." And he has even
more famously been proven correct. But what people miss is, that is exactly how labor
looks at it: "Your gross profit is my wage increase." The Phillips Curve has flattened. We
predict it will rise again. And this will be a function of and a cause of inflation, lower P/E
ratios, and the inverse of the risk-parity trade. We believe the market has dramatically
mis-priced the risk that the populist labor movement presents to future inflation.

The idea behind the risk-parity trade is that having 60% invested in stocks and 40% in
Treasuries cushions equity volatility while nonetheless delivering long term positive
returns. With treasuries nominally near zero and after inflation at or below zero, the
cushion is no longer there, or it is at least quite thin. So the best the risk-parity trade can
imaginably do is hold its own against labor and against wage inflation. There is little to
no upside left in the risk-parity trade, and volatility must be greater since treasuries don't
provide the cushion of yore.

Trump was elected as the middle finger of the forgotten blue-collar worker. If
monetarism and the increase in the power of capital at the expense of labor and the
risk-parity trade have run down to the bitter dregs of the 40-year dis-inflationary cycle,
then we are about to embark on a once in a lifetime shift of power in favor of labor.
Remember, it was Keynes who first pointed out that if interest rates were too low,
capital would be deployed away from labor and into financial assets. If we are right and
inflation makes a comeback, the markets will price capital accordingly, and the Fed, we
now know, prays for precisely this development. Going forward, marginal power will
increasingly go to labor.

Major US Pension Funds: Risk-Free Rate vs. Risk-Adjusted Return Target

2020: 0.55% vs. 7.0%

2010: 4.00% vs. 8.5%

*So, US ten year Treasuries are yielding 3.5% less, but pension funds are still targeting
7%. How's that work?

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 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

Annual Interest on $1,000,000 US Treasury Bond

2020: $5000
2010: $40,000

*risk-parity nightmare is driving capital into commodities. This morning; silver +4%, oil
+3%, gold +2%, copper +1%.

CalPERS (California Pension) Assumed Return

Pensions are positioned for a risk parity nightmare, with $100T if bonds yielding less
than 1.75%, an asset in bonds has become a liability. This number was less that $26T
two years ago. In your traditional risk - parity, 60-40 stock-bond allocation, the fixed
income portion of this portfolio has potentially moved from an asset to a liability. Today,
by our calculation – over 85% of the planet’s bonds yield less than 2%, just two years
ago this number was 36%, using the Bloomberg terminal. Keynes even warned against
distortions/side effects of lowering the cost of capital BELOW a market-driven, natural
rate. Keynes might be considered a right-wing radical today, complete with an Antifa
mob on his front doorstep every morning

Capitalism vs. Democracy

There is always a tension between capitalism and democracy. The former is based on
the idea that the more money you have, the more power you have. It strives for
competitive dis-equilibrium. Invariably this leads to power concentrating into the few, at
the expense of the many. Whereas democracy believes everyone is inherently equal:
one person, only one vote. This can be quite dynamic as well, given the mercurial mood

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 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

swings of the masses. And it enshrines an inequality too, as the minority vote doesn't
control the reins of government. The reason capitalism and democracy can coexist is
because capitalism needs the rule of law in order to function, and this rule of law is best
delivered by a democracy that has an independent judiciary. And since capitalism is
very efficient, dynamic, flexible and creative, the economic pie grows larger for
everyone, despite inequality. The bottom 20% of earners in the USA enjoy a much
higher standard of living today compared to 100 and 200 years ago. Nonetheless, the
tension between wealth concentration and the concomitant ascendancy of capital, vs.
equality and the ascendancy of labor in capitalistic democracies, make for periods of
disinflation and inflation.

CLX Clorox vs. XME Metals and Mining

The XME Metals and Mining ETF continues to outperform Clorox since its colossal
underperformance in March. This ratio heading lower is also a proxy for re-opening
optimism. In our view, the consistent re-opening of the economy combined with building
inflationary pressures points to metals and mining equities continued to outperform the
COVID-safety-net CLX Clorox.

Negative Rates and Deflation

In our view, the future is one of higher interest rates, higher equity volatility, and lower
P/E ratios. A push towards negative nominal U.S. Treasury rates is still a live possibility,
but if that were to happen, an inflationary scenario goes from highly probable to certain.
Why? From a technical analysis perspective, the U.S. Treasury yield chart has a

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

downward channel, the bottom line of which is negative. That alone means it is
possible. Secondly, we have already seen negative sovereign rates elsewhere in the
world, therefore they are possible here. Thirdly, real rates (nominal yields - inflation
expectations) are negative, therefore nominal negative rates are possible. Finally, the
Fed follows the markets. If the markets push rates to nominally negative, it's a fait-
accompli. However, we are not predicting negative rates.

In a negative nominal rate environment, it is more logical to stuff extra cash in a

mattress. This levers the banks and constrains their willingness, and ability, to lend. So
negative rates not only exist in a deflationary environment, but they also predict a
continuation of deflation, and further deflation.

A negative rate environment is the equivalent of a deflationary environment. To say that

negative rates cause inflation, therefore, is identical to saying deflation causes inflation.
That is false in the short term. In the short term, people hoard cash so as to buy more
later, which is logical since cash held's value is growing. However, in the long run, it is
true because the U.S. would do anything to fight deflation. This is empirically observable
in the Fed's behavior. Deflation is generally considered to be bad. That is non-
controversial.

Gold, Bullish

One can make the case that in a deflationary or inflationary world, it's bullish for gold. As
you can see above, gold is still very cheap to equities. The mad mob is still hiding out in
financial assets (tech stocks) and NOT hard assets. As the current risk-parity model
implodes, capital will flow into hard assets. Clearly, we are currently in the early innings
of this trend.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

COVID Ranking

Bloomberg economic's chart above shows how well both frontier and emerging markets
are recovering from COVID. "Asia leads in getting clo ser to pre-outbreak norms, with
some countries in Africa and Eastern Europe also outperforming. Latin America is still
struggling." In our view, Asia's 'COVID outperformance' relative to the west speaks to a
weaker dollar and capital leaving U.S. large-caps for global equities.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

CNH Yuan Strength

Yuan strength is highly supportive of emerging markets, industrials, global

cyclical equities, value equities. CNH strengthened past the 6.80 level. Recovery
momentum, rising trade surplus, and wide yield differential very supportive of the
currency. Expectations that China bonds may be included in the WGBI (ANZ Noted)
could also be helping in its outperformance. China’s retail sales, IP, and fixed
investment beating expectations as China boosts risk sentiment.

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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

PBOC China M2

China: five months after China injected a record 5.2 trillion yuan ($732 billion) in new
total social financing - China's broadest credit aggregate - in March to offset the
catastrophic hit its economy had suffered from the covid pandemic, Beijing once again
surprised to the upside when in August China injected a whopping 3.58 trillion yuan into
its economy ($520 billion), above the highest Wall Street estimate (1 trillion yuan above
the consensus estimate of 2.585 trillion yuan) and the biggest monthly injection since
the March record.

Yuan vs. US - China 10 Year Bonds Yield Spread

The Yuan has strengthened past the 6.80 level, recovery momentum, rising trade
surplus and wide yield differential very supportive of the currency. Expectations that
China bonds may be included in the WGBI (Bond Index) have also helped its
outperformance. Yield differentials point to a Yuan near 5.75, keep in mind, a world of a
5.75 Yuan is an inflationary one with higher long-end yields globally.
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With Larry McDonald
 Part 3 of our Reflation Series: Juggernaut – September 18, 2020

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