Equities

The pandemic-induced recession surely did hurt earnings, but it also served as a wakeup call to corporate executives as they scrambled to boost business efficiencies. The chart below is showing our proxy (using equally weighted industrials/materials/tech/health care/consumer staples and consumer discretionary) for the degree of operating leverage (DOL) for the broad US equity market. The current reading of just below 2 means that an additional 1% increase in sales translates into a nearly 2% increase in earnings. The fact that DOL has rebounded significantly over the past year from negative territory – where it spent the second half of 2019 likely due to capital misallocation brought by excessive share buybacks – also means that the transmission mechanism from top-to-bottom line growth has been unclogged as corporations cleared out the deadwood. Another message from the recovering US equity market DOL is that the current cycle is just getting started, which also supports our secular 2028 SPX 7000 target. Bottom Line: We remain cyclically and structurally bullish on the prospects of the broad equity market, but are keeping our guard up in the near-term.

Highlights The breadth of EM equity outperformance versus DM in H2 last year was poor. This outperformance was largely driven by EM TMT stocks. These EM TMT share prices are now facing challenges and are unlikely to provide leadership for the EM equity index going forward. Meanwhile, the fundamental backdrop of EM ex-TMT equities remains poor. Hence, the EM equity index will for now be in limbo. Feature Over the past year, the EM stock index has done very well in absolute terms and has slightly outperformed the global equity index. Yet, its relative outperformance versus the global equity benchmark has been largely due to TMT (technology, internet and catalog retail, and media and entertainment) stocks.1 The top panel of Chart 1 reveals that EM non-TMT stocks have not really outperformed their global peers. In contrast, EM TMT share prices had considerably outpaced their global counterparts until mid-February (Chart 1, bottom panel). However, odds are that EM TMT share prices will weaken both in absolute terms and relative to global TMT stocks (more on this below). The market-cap weight of EM TMT stocks in the EM MSCI equity benchmark has surged and it presently stands at 41%. This number is 42% for the US, 16% for the euro area and 17% for Japan. Until January, relative outperformance of US and EM stocks versus the global benchmark had been largely due to the outperformance of TMT stocks and their overwhelming weights in the US and EM equity indexes. Further, the EM equal-weight and small-cap stock indexes have failed to outperform their global peers, confirming the lack of breadth in EM outperformance (Chart 2). In brief, the EM stock index has by and large been a one-trick pony. Chart 1EM Outperformance Versus Global Has Been Entirely Due To TMT Stocks Chart 2EM Equal-Weighted And Small Caps Have Not Outperformed   Can the EM equity index both rally in absolute terms and outperform DM stocks if its leaders – TMT companies – encounter challenges? We do not think so. The basis is that fundamentals outside TMT stocks remain lackluster. EM TMT Stocks There are a few reasons why EM TMT stocks will stay under selling pressure: Chart 3TMT Stocks Are Over-Extended The overwhelming headwind for EM TMT stocks is the regulatory crackdown on platform companies in China. Alibaba and Tencent together make up 30% and 11.5% of the MSCI Chinese Investable and MSCI EM equity benchmarks, respectively. Regulatory pressures on them has been growing since October. The recent speech by President Xi implies that the regulatory clampdown is not over. We wrote about how antitrust regulation can affect share prices of these Chinese conglomerates in our November 26 report. US FAANGM stocks as well as Tencent have surged by more than 20-fold since early 2010. That is as much as the Nasdaq100 index during the 1990s (Chart 3). Alibaba and Meituan were listed in 2014 and 2018 respectively so they do not have a ten-year history. We are not suggesting that the share prices of Chinese platform companies will drop by 70% - as much as the Nasdaq 100 index did post its 2000 crest. Our point is that valuation excesses and overbought conditions in Chinese TMT stocks present material downside risk to their share prices when faced with the regulatory clampdown. In addition, rising US bond yields will continue to hurt high-multiples stocks around the world, which include EM TMT stocks, as we discussed in the February 25 Special Report. Technology companies TSMC and Samsung make up 6.6% and 4.3% of the MSCI EM benchmark, respectively. Their valuations are also lofty. Besides, local retail investors played a large role in rallies in both markets last year (Chart 4). It is hard to predict retail investor behavior, but last year’s stampede into stocks could give way to a period of retrenchment. There is another sign of a top for the EM technology and consumer discretionary stocks (Alibaba and Meituan together make 40% of the EM consumer discretionary market cap). Both EM technology (primarily semiconductors) and EM consumer discretionary (internet and catalog retail as well as autos) each make up 20% of the EM benchmark market cap – a threshold that often marks a major peak in their share prices (Chart 5). Chart 4Retail Investors Have Been Driving Korean And Taiwanese Share Prices Chart 5EM Sectors Peak When They Reach 20% Of EM Benchmark   Historically, when the market cap of an EM equity sector reached 20% of the EM MSCI equity benchmark, that marked an apex of its absolute and relative outperformance. This was the case with EM banks in 2013, energy stocks in 2008, and technology in 2000. Within TMT stocks, dedicated EM equity portfolios should favor semiconductor producers versus platform companies. Semiconductor stocks are less expensive and their booming revenues will limit downside in their share prices (Chart 6). Bottom Line: The poor risk-reward profile of TMT stocks implies that the emerging Asian equity benchmark has for now passed the zenith of its relative outperformance against global stocks (Chart 7). Chart 6Asian Semiconductor Companies' Revenues Are Still Booming Chart 7Emerging Asian Stocks Versus Global: A Period Of Underperformance Ahead   Beyond TMT The poor performance of non-TMT stocks has not been limited to the Latin America and EMEA bourses. Emerging Asian non-TMT stocks have also not outperformed their global peers. Chart 8No Bull Market In EM And China ex-TMT Stocks Notably, in absolute terms EM ex-TMT share prices remain below their peak in 2018 (Chart 8, top panel). Besides, Chinese investable non-TMT stocks have not broken out of the trading range that has been in place since 2011 (Chart 8, bottom panel). The following will continue weighing on EM non-TMT stocks: The recovery in many EM economies outside North Asia has been lackluster. Household consumption and capital spending in EM (ex-China, Korea and Taiwan) have been much more subdued than those in the US. These countries are substantially lagging DM economies in vaccinations, delaying the economic normalization and warranting continued economic underperformance. Many EM economies outside North Asia are facing a negative fiscal thrust this year. Their banking systems remain saddled with NPLs and are reluctant to lend. The underperformance of EM (ex-China, Korea, Taiwan) bank stocks versus their global peers corroborates the notion that the monetary transmission mechanism is broken in many of these economies. Without recovery in bank credit, domestic demand will remain lackluster. Rising US bond yields have caused EM (ex-North Asia) local bond yields to spike and currencies to weaken (Chart 9). We expect more upside in US Treasury yields and a  relapse in EM exchange rates. This is bad for their stock markets. Critically, the Chinese economy is now facing triple tightening and its growth will weaken in H2 2021: 1. Monetary and fiscal tightening: The credit and broad money (M3) impulses have already rolled over (Chart 10, top panel). Fiscal policy will also tighten relative to the unprecedented stimulus of last year. This represents a major risk to industrial metals that are very overbought (Chart 10, bottom panel). Chart 9EM (ex-China, Korea And Taiwan): Currencies, Rates And Stocks Chart 10Peak Stimulus In China   The relapse in Taiwanese new orders of basic materials PMI heralds weakness in Chinese material stocks (Chart 11). 2. Regulatory tightening on banks and non-bank financial institutions: Authorities are planning to reinforce asset management regulation by the end of this year. This will limit how much these financial institutions can expand their balance sheets reinforcing a credit slowdown. 3. Property market tightening: Restrictions on both property purchases and property developers’ leverage will lead to a notable slump in real estate construction. Property stocks have formed a tapering wedge and a breakdown is likely (Chart 12, top panel). Besides, their off-shore corporate bond prices are gapping down (Chart 12, middle panel). Chart 11An Apex In Chinese Material Stocks Chart 12Chinese Property Sector Is At Risk   Overall, Beijing’s ongoing policy tightening and resulting economic slowdown will weigh on China ex-TMT stocks that are dominated by banks and old-economy companies. Crucially, onshore small cap stocks have already relapsed suggesting that economic weakness might be broad-based (Chart 12, bottom panel). Bottom Line: Even though EM ex-TMT stocks offer reasonable multiples, their fundamentals remain unexciting. A Review Of Some Of Our Equity Recommendations Chart 13EM Versus Global: Relative Equity Performance 1. We recommend maintaining a neutral allocation to EM stocks in a global equity portfolio. EM relative performance will fluctuate but is likely to stay within a trading range between last May’s low and the recent highs (Chart 13). In regard to other regions, Europe and Japan should outperform the US as global value continues to outperform global growth in next 6-12 months. 2. Long global value / short Chinese investable value stocks. Global value will benefit from the reopening of economies in the US and Europe. Financials, which hold a large weight in the global value index, will be supported by rising global bond yields. Given that multiples on the value stocks are lower than growth stocks, rising bond yields will cause less damage to value stocks. Chinese investable value stocks are heavy in banks. The latter will suffer the consequences of  the credit boom and capital misallocation in China. In a recent special report on China, we estimated that mainland banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In short, Chinese banks have dealt with only 10% of all loans originated since 2009, which is a small number given the magnitude and duration of this credit boom. Hence, we reckon that banks remain saddled with a large amount of NPLs that have not been provisioned for. Outside banks, Chinese investable value stocks will be at risk of ongoing triple policy tightening in China, as discussed above. Chart 14Long Chinese A Shares / Short Chinese Investable Index 3. Long Chinese A shares / short Chinese investable equity index (Chart 14). We recommended this strategy in a March 4 report discussing China’s structural strengths and weaknesses. The primary reason for this recommendation is that the A-share index2  is heavy in value stocks while the MSCI China investable index has a large weight in expensive new economy stocks. The global investment backdrop has shifted in favor of global value versus global growth stocks due to strong US growth and rising US bond yields. Hence, this strategy is consistent with our preference for global value over global growth stocks. Finally, this strategy will benefit from regulatory tightening on platform companies that have a large weight in the Investable index. Chart 15Favor Global Industrials Over Global Materials 4. We have strong conviction that global growth stocks will underperform global value but less conviction that EM growth will underperform EM value. The reasons are as follows: EM value is dominated by EM banks. Not only will Chinese banks suffer from the problems discussed above but also EM ex-China banks are facing many cyclical and structural challenges. Hence, they will benefit less than DM banks from rising bond yields. The EM value index has also considerable weight in energy and material stocks and is light on industrial equities compared to the DM value index. China’s tightening and the ensuing growth slowdown in H2 2021 will weigh more on global materials than on global industrials. Materials are very exposed to China’s construction and infrastructure. China accounts for about 55% of the world’s industrial metals consumption while the US accounts for 7-9%. By contrast, global industrial share prices are more diversified and Chinese demand does not dominate industrial goods to the same extent that it does with industrial metals. Therefore, strong growth in US and European demand and the impending slowdown in China favors global industrial stocks versus global materials. Industrial companies have a larger weight in the DM value index than in the EM value index. By contrast, the materials equity sector has a larger market cap share in the EM value index than in the global value index. In short, investors should favor global industrials versus global materials (Chart 15) over the coming 6-to-12 months and that leads us to have high conviction on the DM value index’s outperformance versus the EM value index. Finally, rising US bond yields will pressure US growth stocks that are heavy in platform companies/new economy stocks. The EM growth index has a large weight in semiconductor producers in Korea and Taiwan that have a better long-term outlook than platform companies. The basis is that TSMC and Samsung have technological advantages over their global peers in producing new, high-performance chips. Such technological advantages give them pricing power in addition to a solid volume expansion. While these Asian semiconductor stocks are very overbought and will likely correct along with global growth stocks, their long-term outlook is positive, and is superior to EM value plays. That is why we have a high conviction view on the underperformance of DM growth stocks relative to DM value ones, but have low conviction on the performance of EM growth versus EM value. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 A TMT stock index refers to a market cap-weighted average of share prices of technology, internet and catalog retail, and media and entertainment. 2 Please note that this is a call for Shanghai- and Shenzhen-listed A shares not the CSI300 index which has a large weight in expensive growth stocks. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Deterioration in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel), and today we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel), and the risk is that the S&P 500 may be next in line (top panel), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Bottom Line: The S&P 500 is nearly perfectly priced and at a spitting distance from our 4,000 end-2021 target. China’s slowdown, especially post the 100 year Communist Party anniversary this summer, remains a key macro risk to monitor and can serve as a catalyst for an SPX correction.  

Highlights Global Duration: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Yield Betas & Country Allocation: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. UK Follow-Up: The conclusions from our UK Special Report published last week do not change after adjusting for the difference in the inflation indices used to calculate UK inflation-linked bond yields compared to those of other countries. UK real interest rates are the lowest in the developed economies, while inflation breakevens are the highest. NOTE: There will be no Global Fixed Income Strategy report published next week. Instead, BCA Chief Global Fixed Income Strategist Rob Robis will do a webcast discussing his latest thoughts on global bond markets. Yields Rising Around The World Chart of the WeekPolicy Mix Is Bond-Bearish The path of least resistance for global bond yields remains biased upward. Optimism on future economic growth remains ebullient with consumer and business confidence indices surging in much of the developed world. The epicenter of the global bond bear market remains the US, where pandemic related economic restrictions are being unwound with 21.4% of the US population now having received at least one dose of a vaccine. Fiscal policy in the US is also supporting the positive vibes on future growth after the $1.9 trillion stimulus package was signed into law by President Biden last week. The 10-year US Treasury yield climbed back to the 2021 high of 1.63% on the back of that announcement. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget (Chart of the Week). This, combined with ongoing quantitative easing from global central banks eager to keep bond yields as low as possible until inflation expectations sustainably return to policymaker targets, is providing a bond-bearish lift to both inflation expectations and real yields – most notably in the US. Central bankers can try to fight back against the speed of the increase in bond yields by maintaining their commitment to current policy settings, as the European Central Bank (ECB) and Bank of Canada (BoC) did last week. The Fed, Bank of England (BoE) and Bank of Japan (BoJ) will all get the chance to do the same this at this week’s policy meetings. The likely message from all will be one of staying the course and not reflexively responding to higher bond yields, which have not triggered a broad-based selloff in global risk assets that would pre-emptively tighten financial conditions. The S&P 500 index hit an all-time high last week, while equity markets in Europe and Japan have returned to pre-pandemic levels (Chart 2). Global corporate credit spreads have remained calm, consistent with a positive growth backdrop that diminishes the potential for credit downgrades and defaults. The US dollar has gotten a lift from improving US growth expectations and relatively higher US Treasury yields, which has had some negative spillover effect into emerging market equities and currencies. The dollar rebound has been relatively modest to date, however, with the DXY index up only 3% from the early 2021 lows. A major reason why global equity and credit markets have absorbed higher bond yields so well is because the sheer scope of the new US fiscal stimulus will have a major impact on growth momentum both in the US and outside the US. This comes on top of the boost to optimism from the speed of the US and UK vaccine rollouts. In an update to its December 2020 economic outlook published last week, the OECD estimated that the $1.9 trillion US stimulus will boost US real GDP growth by 3.8 percentage points versus its original forecast over the next year (Chart 3). Other countries will also benefit from the implied surge in US demand spilling over from that stimulus package, with the OECD projecting a 1.1 percentage point increase to world real GDP growth. Chart 2Risk Assets Ignoring Rising Global Bond Yields Chart 3Big Growth Spillovers From US Fiscal Stimulus Countries that have the greater exposure to US demand, like Canada and Mexico, are expected to benefit a bit more than the rest of the world, but the expected boost to growth is consistent (around one half of a percentage point) from China to Europe to Japan to major emerging market countries like Brazil. That US-fueled pickup in global economic activity will help absorb some of the spare capacity that opened up during the COVID-19 pandemic. In Chart 4 and Chart 5, we show the estimates taken from the December 2020 OECD Economic Outlook for the output gaps in the US, euro area, UK, Japan, Canada and Australia for 2021 and 2022. We adjust those projections by the OECD’s estimate of the impact of the US fiscal stimulus in 2021, as well as by the additional upward revisions to the OECD growth projections in 2021 and 2022 that were published last week. Chart 4The $1.9 Trillion Stimulus Will Close The US Output Gap … Chart 5… And Help Narrow Output Gaps Elsewhere Chart 6Maintain Below-Benchmark Duration The conclusion is that the US output gap will be eliminated in 2022, while output gaps will still be negative, but diminished, in the other countries after factoring in the impact of the latest US fiscal package. This suggests that the maximum upward pressure on global bond yields should still be centered in the US, where inflation pressures will be more evident and the Fed will likely begin signaling a shift to a less dovish stance sooner than other central banks (although not likely until much later in 2021). Our Global Duration Indicator continues to flag pressure for higher bond yields ahead for the major developed economies (Chart 6). The improving growth momentum means that rising real yields should increasingly become the more important driver of higher nominal bond yields. Persistent central bank dovishness in the face of that growth surge, however, means that it is still too soon to position for narrowing global inflation expectations or any bearish flattening of government bond yield curves - even in the US. Bottom Line: Markets are correctly interpreting the $1.9 trillion US fiscal stimulus package as a factor justifying higher global growth expectations and bond yields. Maintain a below-benchmark stance on overall global duration. Using Yield Betas For Bond Country Allocation, One More Time Over the past two months, we have published Special Reports that delved into the outlook for bond yields and currencies in Australia, Canada and the UK. We selected those three countries as they represented the most likely downgrade candidates within our recommended government bond country allocation given their status as “higher beta” bond markets that are more correlated to US Treasury yields. We estimate US Treasury yield betas from a rolling regression (over a three-year window) of changes in 10-year non-US government bond yields to changes in 10-year US Treasury yields (Chart 7). This allows us to assess which markets are more or less sensitive to the ups and downs of US bond yields. We have used this framework to help guide our country allocation strategy during the pandemic and, for the most part, it has been successful. Chart 7Government Bond Yield Sensitivities To USTs Are Shifting Fast So far in 2021, the markets with higher US Treasury yield betas (Canada, Australia and New Zealand) have underperformed the lower beta markets (Germany, France and Japan). We show that in the top panel of Chart 8, which plots the yield betas at the start of the year versus the year-to-date relative return of each country’s government bond market to that of the overall Bloomberg Barclays Global Treasury index. The returns are adjusted to reflect any differences in the durations of each country versus that of the overall index, and are shown in USD-hedged terms to allow for a common currency comparison. The bottom panel of Chart 8 shows the same relationship for the all of 2020. This is a mirror image of what has occurred so far in 2021, with the countries with higher yield betas outperforming the lower beta markets. The obvious difference between the two years is the direction of Treasury yields, which fell in 2020 and have been rising this year. So far in 2020, the differences between the returns of the higher beta markets have been quite similar. New Zealand has had the biggest negative performance (-2.8% versus the global benchmark), but this has only been moderately worse than Australia (-2.6%) and Canada (-2.4%). These are all just slightly worse than the return of US Treasuries relative to the Global Treasury index (-2.3%). Our estimated yield betas have changed rapidly over the past few months. For example, the rolling three-year yield beta of Australia has shot up from 0.61 at the beginning of the year to 0.78, while Canada has seen a similar move (0.81 to 0.88). This reflects the rapid repricing of interest rate expectations in both countries as current growth momentum and growth expectations improve. While not a perfect relationship, yield betas do show some correlation to our Central Bank Monitors – designed to measure the pressure on central banks to tighten of ease monetary policy (Chart 9). The latest increases in the yield betas of Australia, New Zealand and Canada have occurred alongside a rising trend in our Central Bank Monitors for each nation. The implication is that the relative underperformance of government bonds in those countries is related to the cyclical pressure for the RBA, RBNZ and BoC to tighten monetary policy. Chart 8An Intuitive Link Between Yield Betas & Bond Market Performance Chart 9Cyclical Pressures & Yield Betas Are Linked At the same time, the yield betas of government bonds in Germany and the UK have remained low despite the cyclical upturn in our ECB and BoE Monitors. The lingering impact of COVID-19 lockdowns on economic growth and inflation in the euro area and UK is likely weighing on bond yields in both regions. This limits any challenge to the dovish forward guidance of the ECB and BoE, in contrast to the repricing of interest rate expectations seen in other countries. The market-implied path of policy interest rates extracted from OIS forward curves does show a much more aggressive expected path of policy rates in the higher beta markets versus the lower beta markets (Chart 10). Chart 10More Rate Hikes Expected In The Higher Yield Beta Countries​​​​​​​ The “liftoff” date for each central bank shown, representing when the first full interest rate hike is priced into the OIS forwards, is shown in Table 1. We rank the countries in the table by the amount of time until the discounted liftoff date, from shortest to longest. The first rate hike is expected in New Zealand in June 2022, with the BoC expected to lift rates in Canada two months later. The market is not pricing a full rate hike by the Fed until January 2023, while liftoff in the UK and Australia are expected during the summer of 2023. Table 1The "Pecking Order" Of Global Liftoff We treat the countries with perpetually low interest rates, the euro area and Japan, differently in Table 1, as both the ECB and BoJ would most likely move slowly if and when they ever decided to raise rates again. Thus, we define liftoff as only a 10bp increase in policy interest rates for those two regions, while for all the other central banks we assume the size of the first rate hike will be 25bps. On that reduced basis, the market is priced for “liftoff” by the ECB and BoJ in September 2023 and February 2025, respectively. In terms of that “order of liftoff” shown in Table 1, we generally agree with current market pricing except for New Zealand and Canada. We fully expect the Fed to be the first central bank to begin signaling the path towards monetary policy normalization, largely due to the impact of the fiscal stimulus, starting with a move to begin tapering the Fed’s asset purchases at the start of 2022. The Fed will also be the first to begin rate hikes after tapering. We do not anticipate the BoC or Reserve Bank of New Zealand (RBNZ) to make any hawkish moves (reduced asset purchases or rate hikes) before the Fed does the same, as this would put unwanted appreciation pressures on the New Zealand and Canadian dollars. We expect the BoC and RBNZ to move soon after the Fed begins to shift, followed by the BoE and RBA a bit later after that in line with the current liftoff ordering. The pace of rate hikes after liftoff also appears to be a bit too aggressively priced in the countries with higher yield betas. The cumulative amount of interest rate increases to the end of 2024 currently priced in OIS curves is larger in Canada (175bps) and Australia (156bps) than the US (139bps) and New Zealand (140bps). The relative differences are not huge, however, but we think the odds favor the Fed delivering the greater amount of rate hikes over the next three years. More generally, when looking at what is more important for each central bank in determining the timing of liftoff, we can boil it down to a couple of the most important measures for the higher beta countries (Chart 11): US: The Fed will continue to focus on both inflation expectations and broad measures of labor market utilization before signaling any policy shift. On that basis, there is still some way to go before TIPS breakevens return to the 2.3-2.5% level we believe to be consistent with the Fed sustainably hitting its 2% inflation goal on the PCE deflator. Also, there is still a lot of ground to cover before the US labor market fully returns to pre-pandemic health, as the employment/population ratio is four percentage points below the pre-COVID peak. New Zealand: The RBNZ is now under a lot more pressure to tighten policy after the New Zealand government changed the central bank’s remit to include stabilizing house prices, which have soured to unaffordable levels that have exacerbated income inequality. With house prices now rising at a 19% annual rate, the highest since 2004, the RBNZ will be under pressure to hike sooner, although any associated rise in the New Zealand dollar will likely be of equal concern. Canada: The BoC has been very candid that its current policy mix of aggressive asset purchases and 0% policy rates will be altered if the Canadian economy improves. We believe that the current trends of booming house price inflation, recovering business investment prospects and a rapidly recovering labor market will all make the BoC more willing to signal tighter monetary policy fairly soon after the Fed does the same. Australia: The RBA is likely to continue surprising bond markets with its dovishness in the face of a rapidly recovering economy, given underwhelming inflation. In a recent speech, RBA Governor Philip Lowe noted that Australian inflation will not return to the RBA’s 2-3% target band without wage growth rising from the current 1.4% pace up to 3%. The RBA does not expect the labor market to tighten enough to generate that kind of wage growth until at least 2024, suggesting no eagerness to begin normalizing monetary policy. Among the lower-beta markets, the most important things that will dictate future policy moves are the following (Chart 12): Chart 11What To Watch In The Higher Yield Beta Countries Chart 12What To Watch In The Lower Yield Beta Countries UK: The BoE’s current focus is on how fast the UK economy recovers from the pandemic shock, with inflation expectations remaining elevated (see the next section of this report). The degree of strength in business investment and consumer spending will thus dictate the timing of any BoE shift to a less accommodative policy stance. Euro Area: The latest set of ECB projections call for inflation to only reach 1.4% by 2023. As long as inflation (both realized and expected) stays well below the 2% ECB target, the central bank will focus more on supporting easy financial conditions (lower corporate bond yields, tighter Italy-Germany yield spreads and resisting euro currency strength). Japan: Inflation continues to underwhelm in Japan, and the BoJ is a long way from contemplating any tightening measures. Summing it all up, we still see value in using yield betas to dictate our recommended fixed income country allocations. Although these should be complemented with assessments of the relative likelihood of central banks moving before others to further refine country allocations. Bottom Line: Within government bond portfolios, overweighting the “lower-beta” countries that have bond yields less sensitive to changes in US yields (Germany, France, Japan) versus the higher-beta markets (Canada, Australia, UK) remains the appropriate strategy during the current bond bear market. Underweights should remain concentrated in the US, though, as it is highly unlikely that any central bank will begin to tighten policy before the Fed. A Brief Follow-Up To Our UK Special Report In our Special Report on the UK published last week, we noted that the UK had the lowest real bond yields and highest inflation expectations among the developed market countries with inflation-linked bonds.1 Some astute clients pointed out that we neglected to discuss how the UK inflation-linked bonds are priced off the UK Retail Price Index (RPI) which typically runs with a faster inflation rate than the UK Consumer Price Index (CPI). This creates a downward bias to UK real yields in comparison to other countries that use domestic CPI indices in inflation-linked bond pricing. We did not ignore the RPI-CPI differential in our report, we just did not think it to be relevant to the conclusions of our report. The UK still has the lowest real rates and highest inflation expectations even after adjusting both by the RPI-CPI gap (Chart 13). Furthermore, survey-based measures of UK inflation expectations are broadly in line with the RPI-based inflation breakevens, confirming the message from the RPI-based real yields and inflation expectations. Chart 13UK Real Yields Are Too Low, Using RPI Or CPI Looking ahead, the RPI-CPI gap is likely to stay in a much narrower range compared to its longer run history. Chart 14A Less Active BoE Has Narrowed The RPI-CPI Gap For example, between 2000 and 2007, the RPI-CPI gap averaged a full percentage point but with very large fluctuations (Chart 14). This is because mortgage interest costs are included in the RPI but are not part of the CPI. Thus, RPI inflation tends to be more volatile when the BoE is more active in adjusting interest rates. After the 2008 financial crisis, the BoE has kept policy rates at very low levels with very few changes. The RPI-CPI gap has narrowed as a result, averaging only one-half of a percentage point between 2009 to today. Thus, our conclusion on UK bond yields remains the same – Gilt yields are too low and are likely to rise further over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?",dated March 10, 2021, available at gfis.bcaresearch.com and fes.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening in the back half of the year and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Boost exposure in the S&P rails index to overweight. Recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability. The S&P hotels, resorts and cruises index remains a high-conviction overweight. Recent Changes Boost the S&P railroads index to overweight, today. On March 9, our 5% rolling stop on the S&P autos & components index was triggered and we lifted exposure to neutral that netted our portfolio 29% in relative gains since the January 25, 2021 inception. This move also augmented the S&P consumer discretionary sector back to a benchmark allocation resulting in a 7.5% gain.  Table 1 Feature While President Biden signed a new $1.9tn fiscal package into law last week, valid concerns surrounding the path of the 10-year US Treasury yield added choppiness to the stock market’s consolidation phase (Chart 1). Junk bond spreads stayed calm despite the ongoing Treasury bond market selloff and related MOVE index (bond market volatility) jump and remain a key indicator to monitor in order to gauge if a garden variety equity market pullback can morph into something more significant. Recent empirical evidence suggests that the deviation between the MOVE index and junk spreads will likely return to equilibrium via a settling down of the former, as occurred in the May 2013 taper tantrum episode (Chart 2). Chart 1Choppiness Galore Chart 2A Taper Tantrum Repeat? Importantly, delving deeper in the relationship between bonds and stocks and putting it in historical context is instructive. Our sister Emerging Markets Strategy service recently posited that in the coming years the current negative correlation between stock and bond prices will revert to positive as it prevailed prior to the Asian Crisis (Chart 3). The post-1997 era is largely characterized as disinflationary, while the period from the 1960s to the mid-1990s as primarily inflationary. As a reminder core PCE price inflation was last above the Fed’s 2.5% target in the early 1990s (please see grey zone, top panel, Chart 3). Chart 3From Inflation To Disinflation And Back To Inflation? Importantly, what will cement the correlation between stock prices and bond prices becoming definitively positive anew will be a shift upward of core PCE price inflation. Chart 4 shows that core PCE inflation leads the stock-to-bond correlation by 45 months and can serve as a confirming signpost that bonds will no longer offer downward protection to stocks and likely render risk parity useless. Chart 4Joined At The Hip, Albeit With A Lag If this paradigm shift is indeed taking root, this raises two questions: First, how will the broad equity market perform during a more persistent bond market selloff phase? Second, what equity sectors will likely outperform under such a scenario and which ones should equity investors avoid/underweight in their portfolios? Our analysis centered on historically significant bond market selloffs, which we clearly depict in the shaded areas in Chart 5. Chart 5Don’t Fear The Bond Bear Table 2 shows the results of our analysis broken down in two separate eras. Between the 1960s and the early-1990s, “the inflation era”, we use monthly data, whereas from the early-1990s onward, “the disinflation era”, we use high quality daily data. In the seven inflationary iterations the SPX median fall was 3%,1 whereas in the nine disinflationary episodes the SPX median rise was 18%.2 Impressively, since the LTCM debacle every single bond market selloff has been cheered by the stock market (Table 2). Table 2SPX Returns During Bond Bear Markets Table 3 delves deeper into GICS1 sectors and compares relative returns to the SPX during sizable bond market selloffs. Table 3US Equity Sector Returns During Bond Bear Markets During “the inflationary era” deep cyclicals outperformed the broad market, whereas early cyclicals trailed the SPX. The defensives’ performance is split down the middle with telecom and utilities faring poorly, while health care and staples outshining the SPX. One surprising result is that during “the inflationary era” relative tech performance was very resilient compared with what one would expect. There is an accentuation of relative returns in “the disinflationary era”, with all the defensives significantly underperforming and the deep cyclicals broadly outshining the SPX. Early cyclicals make a U-turn and are clear outperformers. One surprising result is the energy sector’s negative median return. Finally, the real estate sector’s significant underperformance really stands out in “the disinflationary era”. Netting it all out, the broad equity market has historically risen consistently in tandem with a bond market sell off primarily in “the disinflationary era”. Impressively, the SPX has been resilient on average even in “the inflationary era”; granted there have also been some notable drawdowns (Table 2). The implication is that at the current juncture the SPX may have some trouble digesting the bond market’s rapid selloff, but will recover smartly especially as the bond market selloff eventually proves more reflective of growth rather than restrictive. (For inclusion purposes, the appendix on page 16 shows the GICS1 sector performance since the 1960s with shaded areas depicting periods of significant bond market selloffs, and similar to Chart 3 the appendix on page 19 plots the relative share price monthly returns correlation to bond price monthly returns.) This week, we update our high-conviction overweight view on an early-cyclical sub-group with a reopening tailwind, and lift a deep cyclical transportation index to an above benchmark allocation. Hop Back On The Rails The Dow Theory is in full force and serves as a confirmation of the breakout in the Dow Industrials recently, as transports have been firing on all cylinders of late, and is also a harbinger of new all-time relative share price highs in railroads (Chart 6). Today we recommend investors get back on board the rails, a key transportation sub group, and lift exposure from neutral to overweight. Chart 6Dow Theory Green Light Leading indicators in all three key rail freight categories suggests that the railroad rebound is still in the early innings. The V-shaped recovery in the ISM manufacturing and services surveys is underpinning total rail shipments and signals that our rail diffusion indicator has more upside (Chart 7). Chart 7All Aboard… The Cass Freight Index shipments and expenditures components are also on a tear and corroborate that demand for rail freight services is robust. The upshot is that still beaten down sell-side analysts’ relative revenue growth estimates will likely surprise to the upside (Chart 8). Importantly, our Railroad Indicator does an excellent job in capturing this firming rail demand backdrop and signals that relative share price momentum has more room to rise (second panel, Chart 9). Chart 8...The Rails Chart 9Intermodal Is On Fire On the intermodal front, the back half of the year economic reopening due to the population’s inoculation along with President Biden's freshly signed fiscal spending bill suggest that retail related hauling services will pick up steam. The overall business sales-to-inventories (S/I) ratio in general and the retail S/I ratio in particular corroborate the upbeat demand outlook for intermodal carloads (third panel, Chart 9). Similarly, the LA port is as busy as ever as containerships are arriving non-stop full of cargo from China (bottom panel, Chart 9). On the commodity front, coal shipments are staging a comeback from extremely depressed levels and there is scope for a jump to expansionary territory especially given the soaring natural gas prices (second & middle panels, Chart 10). With regard to the broad commodity complex (excluding the historically large coal carload category) the demand profile for rail services is as upbeat as ever. Not only are commodity prices galloping higher, but also BCA’s Global Leading Economic Indicator is steeply accelerating painting a bright picture for rail hauling (fourth & bottom panels, Chart 10). Moreover, the surging global PMI signals that the global economic recovery is also on the ascent, which bodes well for relative profit growth (middle panel, Chart 11). Chart 10Commodity Carloads Set To Surge Chart 11Global Recovery Is A Tailwind Importantly, on the operating front our railroad industry profit margin proxy is at an historically wide level and underscores that the path of least resistance is higher for margins (Chart 11). Thus, rail profits are highly levered to industry pricing power that is on the cusp of spiking higher, especially if our thesis of the firming rail demand backdrop is accurate. The implication is that a rerating phase is in the cards for the S&P railroads index (middle panel, Chart 12). Finally, our EPS macro model has slingshot higher and suggests that rail earnings have a long runway ahead (bottom panel, Chart 12). Netting it all out, firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Bottom Line: Boost the S&P rails index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP. Chart 12Pricing Power Holds The Key   Stay Checked In To Hotels In late-November we boosted the S&P hotels, resorts & cruises index to overweight and got some eyebrows raised from our diverse client base. Subsequently, we added this niche consumer discretionary sub-group to our high-conviction overweight list for 2021 and the client pushback intensified. Today, we reiterate our high-conviction call on the S&P hotels, resorts & cruises index that has already added alpha to our portfolio to the tune of 17% since inception. While relative share price momentum has climbed of late and relative valuations have troughed, our sense is that the re-rating phase is just getting under way (Chart 13). As the global push for COVID-19 vaccinations heats up, the semblance of normality will serve as a catalyst to unlock excellent value in hotels.    True, lodging services demand is as downbeat as ever, but this index is a prime beneficiary of the reopening trade. Pent-up services demand will get unleashed with consumers likely indulging on more lavish vacationing starting this Memorial Day. Rising government transfers, a soaring savings rate and increasing incomes all augur well for lodging demand and is also corroborated by our hotels demand indicator (Chart 14). Tack on firming consumer sentiment and the ISM services index staying squarely above the 50 expansion line, and the industry’s demand outlook lifts further.   Chart 13A Valuation Re-rating Phase Looms Chart 14Leading Demand Indicators Give The All-clear Given that hotel capacity has been restrained, there are high odds that upbeat demand will likely catch hoteliers unprepared to fulfil it, and thus causing a jump in selling prices (Chart 15). Business travel is also slated to return as a flexible work place environment becomes the norm and the need to meet clients and prospects in order to conduct business will come back with a vengeance. The implication is that beaten down industry profit margins will recover smartly and boost lodging profitability especially given the collapse in the industry’s wage bill (Chart 15). Finally, our S&P hotels, resorts & cruises macro sales model encapsulates all these moving parts and signals that the budding recovery in revenue growth will gain momentum in the back half of the year (Chart 16). Chart 15Widening Margins Will Restore Profitability Chart 16Macro-based Revenue Growth Model Points To A V-shaped RecoveryAdding it all up, recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability.   Bottom Line: We reiterate the high-conviction overweight status in the S&P hotels, resorts and cruises index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6     Footnotes 1     Given the different time frames of the bond market selloffs we decided to show annualized equity returns. 2     Ibid. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth