Inflation/Deflation

Executive Summary Using the real yield on inflation protected bonds as a gauge of the long-term real interest rate is possibly the biggest mistake in finance. The ultra-low real yield on inflation protected bonds captures nothing more than a stampede for inflation protection overwhelming a tiny supply of inflation protected bonds. The long-term real interest rate embedded in the US bond and US stock markets is likely to be significantly higher than the -0.2 percent real yield on US inflation protected bonds. Long-term investors should overweight conventional bonds and stocks versus inflation protected bonds. On a 6-12 month horizon, overweight both US bonds and US stocks. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-offs both in long duration bonds and in the stock market. Fractal trading watchlist: High dividend stocks, and MSCI Hong Kong versus MSCI China. The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection Bottom Line: The end is in sight for the sell-offs both in long duration bonds and in the stock market. Feature “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so” One of my favourite quotes, ostensibly attributed to Mark Twain, warns us that trouble doesn’t come from what you don’t know. Rather, trouble comes from what you think you know for certain but turns out to be wrong. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. In economics and finance the “what you know for sure that just ain’t so” is the long-term real interest rate. The long-term real interest rate is arguably the most fundamental concept in economics and finance. It encapsulates the risk-free real return on savings, and it is embedded in the returns offered by all assets such as bonds and equities. The trouble is, the way that most people quantify the long-term real interest rate turns out to be wrong. Specifically, most people define the long-term real interest rate as the real yield on (10-year) inflation protected bonds, which now stands at -0.2 percent in the US and -2.3 percent in the UK. US and UK inflation protected bonds will of course deliver the negative long-term real returns that their yields offer. So, most people believe that the long-term real interest rate is still depressed, permitting many rate hikes from the Federal Reserve and Bank of England before monetary policy becomes ‘restrictive’, and providing a massive cushion to asset valuations before they become expensive.This commonly held belief is arguably the biggest mistake in finance. The Long-Term Real Interest Rate Is Not What You Think The biggest mistake in finance stems from the confluence of two factors: first, the inflation protected bond market is the only true hedge against inflation; and second, it is tiny. Compared with the $45 trillion US equity market and the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion. Many other economies do not even have an inflation protected bond market! The ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. When the price level surges, as it has recently, stock and bond investors have a fiduciary duty to seek an inflation hedge, even if they are shutting the stable door after the horse has bolted (Chart I-1). With at least $70 trillion worth of investors all wanting a piece of the $1.5 trillion TIPS market, the demand for TIPS surges, meaning that their real yield collapses. Therefore, the ultra-low real yield on inflation protected bonds captures nothing more than the massive imbalance between huge demand for inflation hedges and tiny supply. Chart I-1When The Price Level Surges, Investors Flood Into Inflation Protected Bonds The proof comes from the perfect positive correlation between the oil price and so-called ‘inflation expectations.’ As a surging oil price drives down the 10-year TIPS yield relative to the 10-year T-bond yield, this difference in yields – which is the commonly accepted definition of expected inflation through 2022-32 – also surges (Chart I-2and Chart I-3). This perfect positive correlation also applies to the so-called ‘5-year, 5-year forward’ inflation rate, the expected inflation rate through 2027-32 (Chart I-4). Chart I-2Inflation Expectations Just Track The Oil Price Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price Chart I-4Even The ‘5-Year, 5-Year Forward’ Inflation Expectation Just Tracks The Oil Price Yet this observed positive correlation between the oil price and inflation expectations is nonsensical, because the reality is the exact opposite! The higher the price level at a given moment, the lower will be the subsequent inflation rate. This is just basic maths. The subsequent inflation rate is the future price divided by the current price, so dividing by a higher price results in a lower number. The empirical evidence over the last 50 years confirms this. The higher the oil price, the lower the subsequent inflation rate (Chart I-5). Chart I-5But A Higher Oil Price Means Lower Subsequent Inflation As the price level surges, subsequent inflation declines, both in theory and in practice. Hence, we should subtract a smaller number from the nominal bond yield to get a higher long-term real interest rate. In other words, all else being equal, the impact of a higher price level is to lift the long-term real interest rate. To repeat, the very low real yield on inflation protected bonds just captures the stampede of inflation hedging demand overwhelming a tiny supply (Chart I-6). Given this distortion, the real yield on inflation protected bonds is likely not the long-term real interest rate embedded in the much larger bond and stock markets. Right now, the long-term real interest rate embedded in the bond and stock markets is likely to be significantly higher than the -0.2 percent real yield on TIPS. Chart I-6The Low ‘Real Bond Yield’ Just Reflects A Massive Demand For Inflation Protection To which the obvious rejoinder is: if the real yield embedded in conventional bonds and stocks is much higher than in inflation protected bonds, why does the market not arbitrage it away? The simple answer is that the market will arbitrage it away, but in slow motion. This is because the mispricing between expected and realised inflation will crystallise in real time, and not ahead of it. Nevertheless, this slow motion arbitrage provides a compelling opportunity for patient long-term investors. Overweight conventional bonds and stocks versus inflation protected bonds. The Best Way To Value The Stock Market Given that we cannot use the yield on inflation protected bonds as a reliable measure of the long-term real interest rate embedded in stock prices, it is also a big mistake to value equities versus the real bond yield. In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities. The basic idea is that the cashflows of any investment can be condensed into one future ‘lump sum payment’. So, we just need to know the size of this lump sum payment, and then to calculate its present value. The US stock market tracks (the 30-year T-bond price) multiplied by (profits expected in the year ahead). For a stock market, the size of the payment just tracks current profits multiplied by ‘a structural growth constant’, and the present value just tracks the value of an equal duration bond. For example, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years.1  It follows that the US stock market price should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a structural growth constant) To the extent that the structural growth outlook for profits does not change, we can simplify the expression to: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) This approach might seem simplistic, yet it perfectly explains the US stock market’s evolution both over the past 40 years (Chart I-7) and over the past year (Chart I-8). Specifically, in 2022 to date, the major drag on the US stock market has been the sell-off in the 30-year T-bond. Chart I-7The US Stock Market = The 30-Year T-Bond Price Times Profits (40 Year Chart) Chart I-8The US Stock Market = The 30-Year T-Bond Price Times Profits (1 Year Chart) For the foreseeable future, we expect profit growth to be lacklustre, keeping the 30-year T-bond price as the dominant driver of the US stock market. With core inflation on the cusp of rolling over and global growth decelerating, the end is in sight for the sell-off in long duration bonds and therefore for the sell-off in the stock market. On a 6-12 month horizon, overweight both US bonds and US stocks. Fractal Trading Watchlist This week, we note that the MSCI index outperformance of Hong Kong versus Chinese has reached a point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2015, 2016, 2018, 2019, and 2020. Therefore, we have added this to our watchlist of investments that are at or approaching turning points, which is available in full on our website: cpt.bcaresearch.com We also highlight that the strong rally in high dividend stocks (the ETF is HDV) is vulnerable to correction if, as we expect, bond yields stabilise or reverse (Chart I-9). Accordingly, the recommended trade is to short high dividend stocks (HDV) versus the 10-year T-bond, setting the profit target and symmetrical stop-loss at 6 percent. Chart I-9The Outperformance Of High Dividend Stocks Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile   Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 19Switzerland's Outperformance Vs. Germany Has Started To End Chart 20The Rally In USD/EUR Could End Chart 21The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. Defined mathematically, it is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Economic Growth in Q2 Will Be Much Softer China’s GDP headline growth in Q1 was better than consensus, but it does not capture the full economic impact of ongoing city lockdowns. Other than infrastructure investment, business activity data from March shows a broad-based slowing in growth momentum. Manufacturing investment decelerated, while both real estate investment and retail sales contracted from a year ago. Exports in value terms continued to grow rapidly through March. However, the resilient rate of expansion is unsustainable given a weakening global manufacturing cycle and softening external demand for goods. China’s domestic supply-chain disruptions will also weigh on its export sector’s activity. Home sales contracted sharply in the first three weeks of April, particularly in larger cities. The lockdowns, coupled with poor funding dynamics among real estate developers, suggest that the real estate sector will remain a huge drag on China’s economy this year. Bottom Line: Even though business activities will resume after the lockdown restrictions are lifted, we do not expect China’s economy to rebound quickly and strongly as it did in 2H20. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio.   A slew of economic data released during the past two weeks suggests that the negative effects from the COVID-induced lockdowns in China’s largest and most prosperous cities are starting to emerge. The closings, which will likely continue through the end of April, are causing disruptions in both production and demand just as the economy was already in a business downcycle. Other than infrastructure spending, business activity data from March illustrates a broad-based slowing in growth momentum. The longer-term impact of the citywide shutdowns is still to come. Related Report  China Investment StrategyThe Cost Of China’s Zero-COVID Strategy The economic benefits of Beijing’s enhanced stimulus measures will be delayed to 2H22 at the earliest. Moreover, as we discussed in our last week’s report, the post-lockdown recovery in the second half of this year will be much more muted than in H2 2020 . The external environment is less reflationary than in 2H20; China’s domestic demand and sentiment among corporates and households were already declining prior to the latest lockdowns. The deteriorating economic outlook will continue to depress the absolute performance of Chinese onshore stocks in the coming months (Chart 1). Furthermore, against a backdrop of rising US Treasury yields, the interest rate differentials between China and US have become negative for the first time in a decade. A yield disadvantage, coupled with risk-averse sentiment across global financial markets, has discouraged portfolio flows into China. We expect foreign investment outflows to continue in the near term before China’s economy stabilizes sometime in 2H22 (Chart 2). Chart 1Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Chart 2...And Have Triggered Substantial Foreign Investment Outflows From a cyclical perspective, we maintain our neutral position on Chinese onshore stocks in a global portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com China’s Credit Conditions: Amble Supply Versus Lack Of Demand Although broad credit growth accelerated in March from the previous month, the improvement mainly reflects a sharp increase in local government bond issuance. Bank loan growth on a year-over-year basis has not improved yet. Loan demand for infrastructure investments escalated, supported by front-loaded fiscal supports in Q1 (Chart 3). However, private-sector credit demand remains very weak. The acceleration in the credit impulse –calculated as a 12-month difference in the annual change in credit as a percentage of nominal GDP –is much more muted when excluding local government bond issuance (Chart 4). Chart 3Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Chart 4The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Sentiment among the corporate and household sectors has plunged to a multi-year low, following two years of stringent COVID-containment measures and last year’s regulatory clampdowns (Chart 5). Furthermore, the corporate sector’s propensity to invest weakened sharply in Q1, despite much looser monetary conditions (Chart 6). A worsening private sector’s sentiment suggests that demand for credit is unlikely to pick up imminently. Chart 5Private-Sector Demand For Credit Remains in The Doldrums... Chart 6...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions Chart 7Significant Foreign Investment Outflows In China's Onshore Bond Market The PBoC announced a 25bps cut in its reserve requirement ratio (RRR) rate on April 15, but has kept its policy rate unchanged. The move was below the market’s expectation of a 50bps RRR cut and/or a policy rate cut. While we still expect that the PBoC will trim the loan prime rate (LPR) in Q2, the recent acceleration in the RMB’s devaluation may make the central bank more cautious in reducing rates and further diverging from the hawkish US Fed and other major central banks  (Chart 7). China GDP: Above-Expectation Growth In Q1, Mounting Concerns In Q2 China’s year-over-year GDP growth in Q1 accelerated to 4.8% from 4.0% in Q4 last year, beating the market expectation of a 4.2% increase. The Q1 growth was mainly supported by strong infrastructure investments and exports (Chart 8). On a sequential basis, however, seasonally adjusted GDP growth in Q1 was 1.3% (non-annualized), slower than Q4’s reading of 1.6% and below its historical mean (Chart 9). Meanwhile, private- sector investment and household consumption remain subdued and activity in the housing sector worsened. Chart 8Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Chart 9Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean The negative effect from broadening city-wide lockdowns and more supply-chain disruptions in Shanghai and surrounding cities in the Yangtze River Delta region will be much larger in Q2 than in Q1. We expect that year-over-year GDP growth in Q2 will drop well below 4%, sharply down from the 4.8% growth recorded in Q1. Furthermore, the aggregate economic impact from the lockdowns could reduce China’s real GDP growth in 2022 by 1ppt, which poses substantial risks to the country’s 5.5% annual growth target for this year. Exports Growth Set To Decelerate Although the growth of exports in value terms remained resilient in March, China’s exports will be challenged this year by the softening global demand for goods and domestic COVID-induced disruptions in the supply chain. A recent PBoC survey of 5,000 industrial enterprises shows that overseas orders dived sharply (Chart 10). In addition, global cyclical stocks have underperformed defensives. The underperformance has historically been a good leading indicator of a global manufacturing downturn, which will likely lead to a decline in demand for Chinese exports (Chart 11). The weakening external demand is also reflected in softening US demand and falling personal consumption expenditures on goods ex-autos (Chart 12).   Chart 10Overseas Orders For Chinese Industrial Enterprises Dived Sharply Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Furthermore, China’s imports for processing trade, which historically has been highly correlated with China’s total exports growth, decelerated sharply in March. The drop heralds a slowdown in the growth of Chinese exports in the coming months (Chart 13). Chart 12External Demand For Chinese Export Goods Will Likely Dwindle Chart 13Slowing Processing Imports Point To A Deceleration In Chinese Export Growth   Port congestions and supply-chain disruptions worsened in April after the Shanghai lockdown began on March 28. COVID-related supply-chain disruptions in China’s key ocean ports and reduced shipping volumes will curtail activity of the country’s export sector in the short term. Real Estate Sector Will Remain A Drag On China’s Economy March’s data reflects a broad-based deterioration in housing market activities (Chart 14). The growth in real estate investment rolled over, and all floor space indicators contracted further in March. Moreover, households’ sentiment in the property market remains lackluster (Chart 15). Funding among real estate developers has plummeted to an all-time low, which will continue to dampen housing construction activities (Chart 16). Chart 14A Broad-based Deterioration In Housing Market Indicators In March Chart 15Housing Market Sentiment Shows Little Signs Of Revival Chart 16Housing Construction Activities Are Set To Slow Further Chart 17Home Sales Worsened In April Amid COVID Flareups In Major Cities The March housing transaction data only captures some early indications from the recent round of lockdowns. The negative upshot on home sales will be greater in April. Figures for high-frequency floor space sold show a substantial weakening in home sales, particularly in tier-one and tier-two cities, through the first three weeks of April (Chart 17). The shrinkage in home sales will likely continue through Q2 and poses a significant risk for property investment and construction activities in H2. Regional governments are allowed to initiate their own housing policies, therefore, an increasing number of regional cities have slashed mortgage rates and/or down payment thresholds (Chart 18). However, the easing measures have failed to shore up demand for housing. In addition, pledged supplementary lending, which the government used to monetize massively excess inventories in the 2015/16 market, resumed its downtrend in March after a short-lived rebound earlier this year (Chart 19). Chart 18More Regional Cities Have Eased Local Housing Policies Chart 19PSL Injections Resumed Downward Trend In March Subdued Domestic Demand And Household Consumption Chart 20Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments China’s domestic demand remained weak in March and will likely worsen in the next few months when more negative fallout from the recent lockdowns spill over to the aggregate economy.   Infrastructure investments picked up strongly in March. However, robust infrastructure investments were insufficient to fully offset the weakness in capital spending in the real estate and manufacturing sectors (Chart 20). The sluggish housing market and a deceleration in exports growth will likely slow China’s capital spending further in Q2. Growth in China’s imports in value terms contracted slightly in March; this was the first time since September 2020. Meanwhile, import growth in volume terms contracted sharply amid weak domestic demand and the early effects of supply-chain disruptions (Chart 21). Moreover, imports of major commodities in volume shrank deeper in March (Chart 22).  Chart 21Chinese Imports Value Growth Fell Into Contraction In March Chart 22The Volume Of China's Key Commodity Imports Contracted Further In March Household consumption has been a laggard in China’s economy in the past two years and the wave of city lockdowns are taking a heavy toll on consumption. Retail sales growth contracted in March, for the first time since August 2020 (Chart 23). Notably, online sales of goods also slowed to a multi-year low, highlighting not only subdued demand but also COVID-related logistic interruptions. Chart 23Retail Sales Growth Slipped Below Zero Chart 24Tame Core And Service CPIs Also Reflect Sluggish Household Demand Weakening core and service CPI readings also reflect a lackluster demand from consumers (Chart 24). We expect that the ongoing lockdowns will continue to weigh on service sector activity and household consumption, at least for the next couple of months (Chart 25). In addition, labor market dynamics are worsening rapidly and the nationwide urban unemployment rate rose to its highest level since mid-2020. The employment situation will also curb household consumption in the medium-term (Chart 26). Chart 26Labor Market Situation Is Deteriorating Sharply Chart 25Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes Strategic Themes Cyclical Recommendations

Executive Summary Summarizing Our Main Investment Themes In One Chart Our current strategic recommendations are centered around four key themes: global inflation will slow over the rest of 2022, Europe remains too weak to handle significantly higher interest rates, corporate default risk in the US and Europe is relatively low, and the fundamental backdrop for emerging markets is poor. If we are going to be proven wrong on any of those themes, it will most likely be because global inflation remains high for longer due to resilient commodity prices and lingering supply chain disruptions. A sluggish economy will handcuff the ECB’s ability to raise rates as fast as markets are discounting over the next year. The state of corporate balance sheet health in the developed world is not problematic, on average, even with some sectors taking on more leverage in response to the 2020 COVID downturn. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. Bottom Line: We remain comfortable with our main fixed income investment recommendations: maintaining neutral global portfolio duration, overweighting core European bonds versus US Treasuries, favoring high-yield corporates over investment grade (both in the US and Europe), and underweighting EM hard currency debt. Feature One of the foundations of a sound medium-term investment process is to allocate capital towards highest conviction views, while constantly assessing - and reassessing - if those views are unfolding as expected. Trades that are not going according to plan may need to be reconstructed, if not exited entirely, to avoid losses. We feel the same way about the investment recommendations highlighted in the pages of our reports, which represent our portfolio, as it were. With this in mind, in this report we identify the four most critical themes underpinning our current main investment recommendations and evaluate the potential risks that our views will not turn out as expected. Theme #1: Global Inflation Will Decline In The Latter Half Of 2022 Our biggest theme for the rest of this year is that global inflation will cool off after the massive acceleration over the past year. Many of our current fixed income investment recommendations across the developed markets – maintaining neutral overall global duration exposure, underweighting global inflation-linked bonds versus nominal government debt, betting against additional yield curve flattening (especially in the US) – are predicated on reduced inflationary pressure on interest rates. Related Report  Global Fixed Income StrategyA Crude Awakening For Bond Investors The expectation of lower inflation is based on some easing of the forces that first caused the current inflationary overshoot – booming commodity prices and rapidly accelerating goods prices due to supply-chain disruptions. Already, the commodity price factor is starting to fade, on an annual rate-of-change basis that matters for overall inflation, thanks to more favorable comparisons to the commodity surge in 2021 (Chart 1). The year-over-year growth rate of the CRB index has decelerated from a peak of 54.4% in June 2021 to 19.3% today, even with many commodity prices seeing big increases in response to the Russia/Ukraine war. This is because the increases in commodity prices were even larger one year ago when much of the global economy reopened from COVID-related economic restrictions. Favorable base effect comparisons are not the only reason why commodity inflation has slowed. Commodities are priced in US dollars, and the steady appreciation of the greenback, with the trade-weighted dollar up 5% on an year-over-year basis, has also helped to slow commodity price momentum (Chart 2). Slower global growth, coming off the overheated pace of 2021, has also acted as a drag on overall commodity price inflation (middle panel). Beyond the commodity space, some easing of global supply chain tensions has resulted in indicators of shipping costs seeing meaningful declines even with supplier delivery times still elevated (bottom panel). Chart 1Our Main Strategic Theme: Decelerating Global Inflation​​​​​​ Chart 2Disinflationary Momentum From Commodities Already Underway​​​​​ A more fundamental factor that should help moderate global inflation momentum this year beyond the commodity/supply chain effects relates to a lack of broad-based global "excess demand", even as the world economy continues to recover from the massive pandemic shock in 2020. The IMF’s latest projections on output gaps – estimates of the amount of spare economic capacity – show that few major developed or emerging market economies are expected to have positive output gaps over 2022 and 2023 (Chart 3). The US is the most notable exception, with an output gap projected to average +1.6% this year and next. Most other developed market countries are projected to have an output gap close to zero. This suggests that the US is facing the most inflationary pressure from an overheating economy, which is why we continue to see the Fed as being the most hawkish major developed market central bank over the next couple of years. Chart 3Few Countries Expected To Have Inflationary Output Gaps In 2022/23 Yet even with so much of the macro backdrop supporting our call for slower global inflation in the coming months, there are several potential risks to that view. Chart 4A Risk To Our Lower Inflation View: Resilient Oil Prices Another war-related upleg in global oil prices Our commodity strategists continue to see oil prices settling down to the low $90s by year-end. Yet oil has seen tremendous volatility since the Ukraine war began as prices had to factor in the potential loss of Russian oil supplies in an already tight crude market. The benchmark Brent oil price briefly hit $140 in the immediate aftermath of the Russian invasion. A similar move sustained over the latter half of 2022 would trigger a reacceleration of oil momentum, putting upward pressure on overall global inflation rates. A renewed bout of energy-induced inflation would push global interest rate expectations, and bond yields, even higher from current levels – a challenge to both our neutral duration stance and underweight bias on global inflation-linked bonds (Chart 4). More supply-chain disruption from China Chinese authorities are clamping down hard on the current COVID wave sweeping across China. The current lockdowns in major cities like Shanghai could shave as much as one percentage point off Chinese real GDP growth for 2022, according to our China strategists. Those same lockdowns in a major transportation and shipping hub like Shanghai are already causing supply chain disruption within China. Supplier delivery times saw big increases in the March PMI data (Chart 5), while the number of cargo ships stuck outside Shanghai has soared. The longer this lasts, the greater the risk that supply chains beyond China would be disrupted, erasing the improvements in global supplier delivery times seen over the past few months. That could keep goods price inflation elevated for longer. Stubbornly resilient services inflation A big part of our lower inflation view is related to a rebalancing of consumer demand in the developed world away from goods towards services as economies move away from COVID restrictions. This implies an easing of the excess demand pressures that have triggered supply shortages for cars and other big-ticket consumer goods. The result would be a sharp slowing of goods price inflation, with the result that overall inflation rates in the major economies would gravitate towards the slower rate of services inflation. The latter, however, is accelerating in the US, UK and Europe (Chart 6) – largely because of soaring housing costs – which raises the risk that overall inflation will fall to a higher floor in 2022 as goods inflation slows. Chart 5Another Risk To Our Lower Inflation View: China Lockdowns​​​​​ Chart 6One More Risk To Our Lower Inflation View: Sticky Service Prices In the end, we see the balance of risks still tilted towards much slower global inflation this year. However, if we are going to be proven wrong on any of our major investment themes in 2022, it will most likely be because global inflation remains resilient for longer. Theme #2: Europe’s Economy Is Too Fragile To Handle Higher Interest Rates Beyond the global inflation call, our next highest conviction view right now is that markets are overestimating the ECB’s ability to tighten euro area monetary policy. Markets are now pricing in 85bps of ECB rate hikes by the end of 2022, according to the euro area overnight index swap (OIS) curve, which would take policy rates back to levels last seen before the 2008 financial crisis. The war has put the ECB in a difficult spot vis-à-vis its next policy move. High euro area inflation, with annual headline HICP inflation climbing to 7.4% in March and core HICP inflation reaching 2.9%, the highest level of the ECB era dating back to 1996, would justify a move to begin hiking policy interest rates as soon as possible.   However, European growth momentum has slowed significantly so far in 2022. Initially this was due to the spread of the Omicron COVID variant that resulted in a wave of economic restrictions. That was followed by the shock of the Russian invasion of Ukraine, that has hit European economic confidence and raised fears that Europe would lose access to Russian energy supplies. Our diffusion indices of individual country leading economic indicators and inflation rates within the euro area highlight the pickle the ECB finds itself in (Chart 7). All countries have headline and core inflation rates above the ECB’s 2% target, yet only 60% of euro area countries have an OECD leading economic indicator that is higher than year ago levels. In the three previous tightening cycles of the “ECB era” since the inception of the euro in 1998, the diffusion indices for both growth and inflation reached 100% - in other words, every euro area economy was seeing faster growth and above-target inflation. Chart 7The ECB Will Have Difficulty Hiking As Much As Expected Chart 8Warning Signs On European Growth Other economic data are also sending worrying messages. The euro area manufacturing PMI fell to the lowest level since January 2021 in March, while the European Commission consumer confidence index and the ZEW expectations index have plunged to levels last seen during the depths of the 2020 COVID recession (Chart 8). Euro area export growth has also decelerated sharply, with exports to China contracting on a year-over-year basis. Simply put, these are not the kind of growth data consistent with a central bank that needs to begin tightening policy aggressively. The inflation data also does not paint a clean picture for the ECB. ECB President Christine Lagarde has repeatedly noted that the central bank is on the lookout for any “second round effects” from the current commodity-fueled surge in European inflation on more lasting inflationary measures like wages. On that front, European wage growth remains stunningly subdued. European annual wage growth was only 1.6% in Q4/2021, despite the unemployment rate for the whole euro area falling below the OECD’s full employment NAIRU estimate of 7.7% (Chart 9). Unit labor costs only grew at an 1.5% annual rate at the end of 2021, suggesting little underlying pressure on European inflation from wages. Chart 9No Inflationary Pressures From Wages In Europe​​​​​ Chart 10European Bond Yields Discount Too Much ECB Hawkishness Without a bigger inflation boost from labor costs, the ECB will feel less pressured to begin tightening monetary policy as rapidly and aggressively as markets are discounting – especially if global goods/commodity inflation slows as we expect. We remain comfortable with our overweight recommendation on core European government bonds (Germany and France), both within a global bond portfolio but especially versus the US. The Fed is far more likely to deliver the aggressive rate hikes discounted in money markets compared to the ECB (Chart 10). Theme #3: Corporate Default Risk In The US And Europe Is Relatively Low Another of our main investment themes relates to corporate credit risk. Specifically, we see high-yield debt in the US and Europe as being relatively more attractive than investment grade credit, even in a typically credit-unfriendly environment of tightening global monetary policy and slowing global growth momentum. Our Corporate Health Monitors are highlighting that corporate finances are in relatively good shape on either side of the Atlantic (Chart 11). This is primarily related to strong readings on interest coverage, free cash flow generation and profit margins, all of which are helping to service higher levels of corporate leverage. Defaults are expected to rise over the next year in response to slowing growth momentum, but the increase is projected to be moderate. Moody’s is forecasting the US and European high-yield default rates to be virtually identical, climbing to 3.1% and 2.6%, respectively, by February 2023. Those relatively low default rates, however, are for the aggregate of all high-yield borrowers. Default risks may be higher for some companies and industries that were more severely impacted by the pandemic. Chart 11US/Europe Default Risk Remains Relatively Modest​​​​​ Chart 12The IMF Sees Fewer Financially Vulnerable Firms​​​​​​ Chart 13Default-Adjusted HY Spreads Still Offer Some Value An analysis of global private sector debt included in the latest IMF World Economic Report highlighted that companies that suffered the most significant declines in revenues in 2020 also took on greater amounts of debt than companies whose businesses were least impacted by the 2020 growth shock (Chart 12). Industries that were “worst-hit” by COVID also saw significant worsening of debt servicing capability, described by the IMF analysts as the percentage of firms among the “worst-hit” that had interest coverage ratios less than one (middle panel). Importantly, the IMF report noted that the “worst-hit” industries have seen significant improvements in interest coverage since 2020, reducing the number of financially vulnerable firms (those with high debt-to-assets ratios and interest coverage less than one). The IMF analysis uses corporate data from a whopping 71 countries, but the conclusions are like those from our Corporate Health Monitors for the US and Europe – corporate credit quality has improved, on the margin, since the dark days of the 2020 COVID recession for an increasing number of borrowers. Default-adjusted spreads for high-yield bonds in the US and Europe, which subtract expected default losses from high-yield index spread levels, show that high-yield bonds currently offer decent compensation for expected credit losses (Chart 13). This is especially true for European high-yield, where the default-adjusted spread is just below the average level since 2000. This fits with our current recommendation to maintain neutral allocations to both US and European high-yield. We have a bias to favor the latter, however, due to better valuation metrics and a more dovish outlook on ECB monetary policy compared to the Fed. Theme #4: The Fundamental Backdrop For Emerging Markets Is Poor Chart 14The Backdrop Remains Challenging For EM We have been negative on emerging market (EM) credit dating back to the latter months of 2021. Specifically, we are now underweight EM USD-denominated debt, both sovereigns and corporates. This is a high-conviction view and one that remains fundamentally supported. A sustainable rebound in EM markets would require a “perfect storm” combination of events to occur – aggressive China policy stimulus, a de-escalation of Russia/Ukraine tensions, a weaker US dollar and diminished global inflation pressures. While we expect the latter to occur in the coming months, there are meaningful risks to that view, as described earlier. Meanwhile, the situation in Ukraine appears to be worsening with Russia pushing the offensive and showing no desire for reengaging talks with Ukraine. Chinese policymakers are starting to respond to slowing Chinese growth, made worse by the COVID lockdowns, with some easing measures on monetary policy. Credit growth has also started to pick up, but the credit impulse remains too weak to warrant a more positive view on Chinese growth and import demand from EM countries (Chart 14). Finally, the US dollar remains well supported by a hawkish Fed and widening US/non-US interest rate differentials. This may be the most critical variable to watch before turning more positive on EM credit, given the strong historical correlation between the US dollar and EM hard currency spreads (bottom panel). For now, the trend of the US dollar remains EM-negative. Concluding Thoughts Chart 15Summarizing Our Main Investment Themes In One Chart Our four main investment themes, and associated recommendations, are summarized in Chart 15. The credit-related themes – underweighting high-yield bonds in the US and Europe versus investment grade equivalents, and underweighting EM USD-denominated debt – are already performing as expected. The interest rate related themes – slower global inflation and fading European rate hike expectations – should unfold in favor of our recommendations over the balance of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Chart 2Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Chart 6The Clogged-Up Port Of Shanghai Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Brent Stable As Demand + Supply Fall Oil demand growth will slow this year and next by 1.6mm b/d and 1mm b/d, respectively. These expectations are in line with sharp downgrades in World Bank and IMF economic forecasts, which cite pressures from the Ukraine War, COVID-19-induced lockdowns in China, and central-bank policy efforts to contain rising inflation. Lower oil demand will be offset by lower supply from Russia and OPEC 2.0, which now are ~ 1.5mm b/d behind on pledges to restore production taken from the market during the pandemic. In 2022, US production will increase ~750k b/d year-on-year. The strategic relationship between the US and core OPEC 2.0 producers Saudi Arabia and the UAE is fraying. The Core's unwillingness to increase production despite pleas from the Biden administration likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian storage to fill, and lead to production shut-ins. Oil prices would surge to destroy enough demand to cover this loss. Our base-case Brent forecast is at $94/bbl this year and $88/bbl in 2023, leaving our forecast over the period mostly unchanged. Bottom Line: Despite major shifts in global oil supply and demand over the past month, oil markets have remained mostly balanced. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs. Feature Related Report  Commodity & Energy StrategyDesperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma Oil demand and supply growth are weakening on the back of the Ukraine War, COVID-19-induced lockdowns in China, and central-bank efforts to contain rising inflation. We expect global demand growth to slow this year and next by 1.6mm b/d and 1mm b/d, respectively, in line with downgrades in IMF and World Bank global growth forecasts.1 Demand will fall to 100mm b/d on average this year, down from our earlier expectation of 101.5mm b/d published in March. For next year, we expect global oil consumption to come in at 102.2mm b/d, down from our March estimate of 103.2mm b/d (Chart 1). EM consumption, the engine of oil-demand growth, falls to 54.2mm b/d vs. 55.8mm b/d in last month's forecast for 2022 demand. We have been steadily lowering our estimate for 2022 Chinese demand this year due to its zero-tolerance COVID policy and its associated lockdowns, and again take it down 250k b/d in this month's balances to 15.7mm b/d on average. In our estimates, Chinese oil demand grows 2.6% from its 2021 level of 15.3mm b/d. We have been expecting DM oil consumption to flatten out this year, following massive fiscal and monetary stimulus fueling oil demand during and after the pandemic, and continue to expect it to come in at ~ 45.7mm b/d this year. Chart 1Sharply Lower Oil Demand Expected Oil Supply Gets Complicated Oil supply will continue to weaken along with demand this year, primarily due to sanctions imposed on Russia by Western buyers following its invasion of Ukraine. Russia's production reportedly was just above 10mm b/d. Estimates of Russian production losses over 2022-23 range from 1mm b/d to as much as 1.7mm b/d over at the US EIA. The outlier here is the IEA, which warns Russian production will fall 1.5mm b/d this month, then accelerate to 3mm b/d beginning in May. In our base-case modeling, we expect Russian output to average 9.8mm b/d in 2022 and 9.9mm b/d next year (Chart 2). Tracking Russia's production became more complicated, as the government this week announced it no longer would be reporting these data. Prices and satellite services will be needed to impute Russia's output in the future. Russia and the Kingdom of Saudi Arabia (KSA) are the putative leaders of OPEC 2.0 (otherwise known as OPEC+). In the wake of Russia's invasion of Ukraine, OPEC, the original cartel led by KSA, continues to maintain solidarity with Russia, referring in its Monthly Oil Market Report (MOMR), for example, to the "conflict between Russian and Ukraine," or the "conflict in Eastern Europe" – not the war in Ukraine. This would suggest KSA and its allies continue to place a high value in maintaining the OPEC 2.0 structure, which has shown itself to be an extremely useful organization for managing production and production declines among non-Core states – i.e., those states outside the Gulf that cannot increase output, or are managing declining production due to lack of capital, labor or both (Chart 3). Chart 2Brent Stable As Demand + Supply Fall Chart 3OPEC 2.0 Remains Useful To KSA And Russia The strategic relationship between core OPEC 2.0 producers capable of maintaining higher production – KSA and the UAE – and the US is fraying. Both states showed no interest in increasing production despite pleas from the Biden administration following Russia's invasion of Ukraine, and have shown a propensity to expand their diplomatic and financial relationships, e.g., exploring oil sales denominated in Chinese RMB, beyond their US relationships.2 This likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. Outside the OPEC 2.0 coalition, we continue to expect higher output from the US, led by shale oil production. According to Rystad Energy, horizontal drilling permits in the Permian basin hit an all-time high in March.3 If these permits are converted into new projects, oil supply growth will be boosted starting 2023. The US government’s recent announcement to lease around 144,000 acres of land to oil and gas companies – in a bid to bring down high US oil prices – also will spur supply growth towards the beginning of next year.4 These bullish factors are balanced out by nearer-term headwinds. Bottlenecks resulting from pent-up demand released following global lockdowns, the Russia-Ukraine crisis, and investor-induced capital austerity means US oil producers will not be able to turn on the taps as quickly this year as they've been able to do in days gone by. Given the near-term bearish factors and longer-term bullish factors, we expect total US crude production to grow slower this year and ramp up at a faster pace the next. US shale output (i.e., Lower 48 states (L48) ex Gulf of Mexico) is expected to average 9.73mm b/d in 2022 and 10.53mm b/d in 2023 (Chart 4). Total US crude supply is expected to average 11.92mm b/d and 12.74mm b/d, respectively, over this period. Additional production increases are expected from Canada, Brazil and Norway. Chart 4Shales Continue To Pace US Onshore Output Increases Upside Risk Remains KSA's and the UAE's strategy to hold off on production increases despite US entreaties upends one of our expectations – i.e., that these state would increase production as the deficit in OPEC 2.0 output being returned to the market widened. We are coming around to the idea this could represent a desire to diversify their exposure to USD payments and assets, which, as Russia's invasion of Ukraine demonstrated, can become liabilities in an economic war. This also would begin to reduce the heavy reliance KSA and the UAE place on the US vis-à-vis defending its interests.5 Lastly, we would observe KSA's and the UAE's spare capacity is being husbanded closely, given it constitutes most, if not all, of OPEC 2.0's 3.4mm b/d of spare capacity (Chart 5). There are multiple scenarios in which this spare capacity would be needed by global markets to address production outages. One of the most imposing is an EU embargo on Russian oil imports floated by France this week, which triggers a cut-off of natural gas supplies by Russia to the EU.6 An embargo of Russian oil imports by the EU is a very low-probability event, but it is not vanishingly small. The EU imports about 2.5mm b/d of Russia's crude oil exports. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian pipelines and storage to fill, and would lead to production shut-ins. Oil prices would have to surge to destroy enough demand to cover this loss of supply, even after OPEC's spare capacity was released into the market. If realized, such an event also would throw the world into recession, in our view. The prospect of a cut-off of Russian oil imports by the EU was addressed last month by Energy Minister Alexander Novak, who said such an act would prompt Russia to shut down natural gas exports to the EU.7 If Russia follows through on such a threat, it would shut down much of the EU's industrial and manufacturing activity. The experience of this past winter – when aluminum and zinc smelters were forced to shut as natural gas prices surged and made electricity from gas-fired generation too expensive for their operations – remains fresh in the mind of the market. An oil-import ban by the EU followed by a cut-off of natgas exports by Russia almost surely would spike volatility in these markets (Chart 6). In addition, a global recession would be a foregone conclusion, in our view. Chart 5OPEC Spare Capacity Concentrated In KSA, UAE Chart 6Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Markets Remain Roughly Balanced … For Now Our supply-demand modeling indicates production losses are roughly balanced by consumption losses at present (Chart 7). If anything, the lost demand slightly outweighs the loss of production, when we run our econometric models. However, we are maintaining a $10/bbl risk premium in our estimates for 2022-23 Brent prices, which keeps our current forecast close to last month's levels. Persistent strength in the USD, particularly in the USD real effective exchange rate, acts as a headwind on prices by making oil more expensive ex-US (Chart 8). We expect this to continue, given the Fed's avowed commitment to raise policy rates to choke off inflation, which, all else equal, will make USD-denominated returns attractive. Chart 7Markets Remain Mostly Balanced Chart 8Strong USD Restrains Oil Prices Investment Implications Despite the major shifts in oil supply and demand over the past month, markets have remained mostly balanced (Table 1). Falling Russian output and weak OPEC 2.0 production – where most states are managing production declines – is being exacerbated by falling Chinese demand and SPR releases from the US and IEA. The market does not yet need the 1.3mm b/d of Iranian output that is being held at bay due to a diplomatic impasse between the US and Iran, which we believe will persist. With overall economic output growth slowing – per the forecasts of the major supranational agencies (WTO, IMF, World Bank) – weaker demand can be expected to persist. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This is not to say upside risk is non-existent. A move by the EU to ban Russian oil imports could set in motion sharply higher oil and gas prices and a deep EU recession, as discussed above. This could trigger an immediate need for OPEC spare capacity and those Iranian barrels waiting to return to export markets. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish Russia's concentration of exposure to OECD Europe – as customers for its energy exports – exceeds the latter's concentration of imports from Russia by a wide margin. Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this Russia exported last year, OECD Europe was its largest customer, accounting for 50% of total oil exports, according to the US EIA (Chart 9). On the natgas side, more than one-third of the ~ 25 Tcf of natgas produced by Russia last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 84% – was exported via pipeline to the OECD Europe, with the biggest customers being Germany, Turkey, Italy and France. As is the case with crude oil and liquids, OECD Europe is Russia's biggest natgas customer, accounting for ~ 75% of exports in either gaseous or liquid form. There is an argument to be made Russia needs OECD Europe as much or more than the latter needs Russia. Ags/Softs: Neutral Grains and vegetable oils are at multi-year or all-time highs, as a result of the war in Ukraine. This week, corn futures hit the highest since 2012, while wheat futures surged amid the ongoing war and unfavorable weather in U.S. growing areas. The U.N. Food and Agriculture Organization's Food Price Index rose 12.6% from February, its highest level since 1990. According to the FAO, the war in Ukraine was largely responsible for the 17.1% rise in the price of grains, including wheat and corn. Together, Russia and Ukraine account for around 30% and 20% of global wheat and corn exports. The cost of fertilizers has increased by almost 30% in many places due to the supply disruptions caused by the war and the tightening of natural gas markets, which is being driven by EU efforts to diversify away from Russian imports of the commodity.8 Planting is expected to be very irregular in the upcoming grain-sowing months, navigate through much higher prices for fuel and fertilizers (Chart 10). Chart 9 Chart 10     Footnotes 1     Please see the IMF's April 2022 World Economic Outlook report entitled War Sets Back the Global Recovery, and the World Bank's Spring Meetings 2022 Media Roundtable Opening Remarks by World Bank Group President David Malpass, posted on April 18, 2022. 2     Please see, e.g., Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales published by wsj.com on March 15, 2022.   3    Please see Permian drilling permits hit all-time high in March, signaling production surge on the horizon, published by Rystad Energy on April 13, 2022. 4    Please see Joe Biden resumes oil and gas leases on federal land, published by the Financial Times on April 15, 2022. 5    Please see Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma, which we published on January 14, 2014. In that report, we noted, "… the U.S. has decided to stop micromanaging the Middle East. The latter policy sucked in too much of Washington's material resources, blood and treasure, at a time when regional powers like China and Russia were looking to establish their own spheres of influence in East Asia and Eurasia respectively." Building deeper commercial relationships with China also would bind both states together in terms of addressing KSA's security concerns, given China's existing relationships with Iran. This is a longer-term strategy, in our view. 6    Please see An EU embargo on Russian oil in the works - French minister, published by reuters.com on April 19, 2022. 7     Please see War in Ukraine: Russia says it may cut gas supplies if oil ban goes ahead, published by bbc.co.uk on March 8, 2022. 8    Please refer to Food prices soar to record levels on Ukraine war disruptions, published by abcNEWS on April 8, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary After having overspent on goods ex-autos over the past two years and experiencing contracting incomes in real terms, US and European households will reduce their purchases of goods ex-autos. Risks to global growth stemming from China remain to the downside. Leading indicators from Asia and global financial markets are signaling a contraction in global trade. Yet, US core inflation will not drop below 4% for the rest of this year. Consequently, the Fed will likely end up hiking rates and sounding hawkish amidst a major global trade slump. This will give rise to stagflation anxiety among investors and will be negative for global risk assets in general and EM equities, currencies and credit markets in particular. The yuan is breaking down versus the US dollar. A weaker RMB will pull down Emerging Asian as well as other EM currencies. Does This Divergence From A Historic Correlation Signify Stagflation? Bottom Line: Global equity and credit portfolios should remain defensive and continue underweighting EM. Currency investors should be positioned for another upleg in the US dollar and a downleg in EM currencies. Feature The volume of global trade is about to contract. Meantime, US inflation will remain well above the Fed’s target. This combination will produce stagflation anxiety among investors. It is impossible to know whether stagflation will be a long-lasting phenomenon in the real economy. In our view, the stagflation narrative will dominate global financial markets in the coming months. This heralds a cautious stance on global and EM risk assets. The slowdown in global manufacturing and trade will be pervasive and broad-based but will exclude auto production. The latter will in fact recover as chip/input shortages ease. The main drivers of the slowdown are (1) a mean reversion in US and European demand for goods ex-autos; (2) China’s economic woes and (3) moribund domestic demand in mainstream EM. Shrinking DM Household Demand For Goods ex-Autos Chart 1DM Household Demand For Goods ex-Autos Will Experience Mean Reversion After having overspent on goods ex-autos over the past two years and experiencing contracting income in real terms (after adjusting for inflation), US and European households will reduce their purchases of goods ex-autos. US and European consumption of goods ex-autos exploded at the onset of the pandemic two years ago and has stayed robust until now. Chart 1 illustrates that since mid-2020, the consumption of goods ex-autos was running well above its trend, which signifies excessive demand over the past two years. Such excessive demand has led to bottlenecks and shortages, giving producers an opportunity to hike prices. In a nutshell, inflation in tradable goods in the past 18 months was primarily driven by demand, not supply constraints. A portion of future goods consumption has been pulled forward, which implies that household demand for these goods has become saturated. Moreover, as the pandemic subsides, consumers are shifting their spending from goods to services. These dynamics could create an air pocket in the demand for certain goods. Chart 2DM Household Real Incomes Are Contracting Critically, US and European household income is contracting in real terms (Chart 2). Wage growth has not kept up with the surge in inflation. Due to shrinking disposable real income, consumers in advanced economies will curtail their consumption of discretionary items, primarily goods ex autos on which they have overspent during the past two years. Bottom Line: Demand for goods ex-autos will shrink in advanced economies in the next 6-12 months. This will weigh on global merchandise trade. China’s Trilemma Chinese authorities are facing an “impossible trinity” in their attempts to simultaneously achieve three objectives: (1) pursuing the dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. We do not think all three objectives can be achieved. China’s economy was struggling prior to the recent lockdowns. The COVID-related restrictions have only made matters worse and have weighed heavily on economic activities and household income. Domestic orders for industrial enterprises plunged below 50, i.e., they are in contraction territory (Chart 3). These surveys, released on March 30-31, were not affected by the Shanghai lockdowns, which have proliferated since March 28. Exports orders are also contracting (Chart 4). Chart 3China: Domestic Orders Were Plunging Prior To Lockdowns Chart 4China: Exports Are Set To Contract   Further, China’s import and export volumes were contracting in January – prior to the Ukraine war and the recent lockdowns. Notably, Chart 5 highlights that prior to the recent lockdowns, import weakness was broad-based, including commodities, machinery and semiconductors. In particular, total imports in USD are flat in March compared to a year ago. With commodity prices up significantly, it is clear that import volumes in March have shrunken substantially. National disposable income per capita was growing at about 6% in nominal terms before the lockdowns (Chart 6, top panel). Household mortgage growth had decelerated considerably before lockdowns became widespread (Chart 6, bottom panel). Chart 5Chinese Imports Were Shrinking Before Lockdowns Chart 6China: Household Income And Mortgage Borrowing ​​​​​​​​​​​​​​​​​​​​​   As the lockdowns wreak havoc on the economy and household income, and with the government not providing direct transfers to the population, household consumption will be severely affected in the months ahead. The property market remains in the doldrums and is unlikely to recover soon. As we have highlighted in previous reports, structural headwinds, continue to weigh down on the property market. Since 2009, there has been no business cycle recovery in China without the real estate market playing the leading role. Residential floor space sold was down by 20% in Q1 from a year ago (Chart 7, top panel). House prices have begun deflating in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Critically, the plunge in property developers’ financing entails shrinkage in housing completion (construction work) (Chart 7, bottom panel). The latter has so far held up as authorities have been forcing developers to use their limited financing to complete projects that they had already started. The massive issuance of local government bonds will spur an acceleration in infrastructure spending. China’s government gave the green light already this year to infrastructure projects worth nearly 70% of what was allowed for the whole of last year. Yet, this might be insufficient to produce a rapid business cycle recovery in an environment of rolling lockdowns and with other segments of the economy facing challenges. Related Report  Emerging Markets StrategyGlobal Semi Stocks: More Downside Given these negative forces, the Chinese economy requires massive government stimulus in the form of direct transfers to households and SMEs – as the US offered in the spring of 2020. Yet, it does not seem that the government is rushing to provide such direct and significant stimulus. In our opinion, the policy stimulus measures announced so far by the government fall short of what is required to lift the economy. Policymakers are neither ready to abandon the dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. With these two constraints, economic growth in China is set to underwhelm. Bottom Line: Risks to global growth stemming from China remain to the downside. In EM ex-China, ongoing fiscal tightening, monetary tightening in LATAM and feeble household income growth in India and ASEAN will all cap consumer spending and business investment (Chart 8). Chart 7China: Property Construction Is Set To Shrink Chart 8EM ex-China: Domestic Demand Will Remain Sluggish Signs Of A Global Trade Contraction There is already evidence to suggest that a major relapse in global manufacturing and trade is beginning: Taiwanese shipments to China are dipping into negative territory, and they lead global exports (Chart 9). Taiwanese exports to China are a good leading indicator of global trade dynamics because mainland producers order inputs from Taiwan first before they produce final goods for export. When producers located in China order less inputs, they evidently expect less in the way of production and shipments. Korea’s business survey of exporting companies indicates a substantial deterioration in their business conditions in April (Chart 10). This points to a major slump in the nation’s exports and, hence, global trade. Chart 9Global Trade Is Set To Contract Chart 10Korean Exporters Are Downgrading Their Expectations Korean and Japanese non-financial share prices have plunged despite considerable currency depreciation, which is typically positive for their competitiveness. As many of these non-financial companies are major exporters, this development points to a major downtrend in global trade. Global cyclicals have been underperforming global defensives. This dynamic has historically been a good leading indicator for the global industrial downturn (Chart 11). Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives (Chart 12). This also points to a slowdown in US growth. Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Chart 12Beware Of A Relapse in US Early Cyclical Stocks   Bottom Line: Leading indicators from Asian economies and global financial markets are signaling that global trade will experience a contraction and global growth will slow. Inflation Amid A Global Trade Contraction? Chart 13US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms A natural question is why worry about inflation when global trade volumes will be contracting? The primary source of anxiety in this context is US inflation and the Fed’s tightening. A decline in global trade will not be enough to bring down US core inflation substantially. By contrast, China and Asia do not face an inflation problem. US inflation worries will persist, and the Fed will likely continue to hike rates and sound hawkish for the following reasons: First, US capital expenditures by companies and household spending on services will remain robust. US services make up a larger share of the American economy and employment than do goods-producing sectors. Hence, we do not expect a broad-based recession in the US this year. Second, as we have previously noted, the US has a genuine inflation problem. American wages are accelerating, and a tight labor market will push up wage growth above 5-6% (Chart 13, top panel). Importantly, real wages in the US have contracted (Chart 13, bottom panel). Faced with a decline in purchasing power, employees will demand higher wages. The tight labor market raises the odds that companies will likely accommodate higher wages. Chart 14Unit Labor Costs Are The Key To Core Inflation Given that US productivity growth is no more than 1.5-2%, wage growth over 5-6% means that unit labor costs will be rising by more than 3-4%. This will prevent core inflation from falling a lot. Unit labor costs have historically been the main driver of core inflation in the US (Chart 14). Finally, inflation is a lagging and inert phenomenon. It takes a long time (more than six to nine months) of sub-par growth for inflation to subside. Odds are that even though global trade volumes will be contracting, the Fed will continue hiking rates and sounding hawkish because US inflationary pressures will remain acute. Bottom Line: Annual core CPI inflation will drop in the US due to the base effect and a drop in some goods prices. Yet, we expect core CPI and PCE to remain above 4% for the rest of this year. Underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be reduced meaningfully without bringing economic growth down below potential growth and weakening the labor market for a few quarters. Investment Implications Shrinking global trade volumes and a hawkish Fed are bearish for global risk assets in general and EM equities, currencies and credit markets in particular. Contracting exports and a hawkish Fed are negative for the Chinese yuan and other Asian currencies. The CNY/USD exchange rate has broken below its 200-day moving average and odds are that it will depreciate further (Chart 15). Our target for CNY/USD is 6.7. The broad trade-weighted US dollar has more upside and EM currencies will depreciate. Chart 16 illustrates that investors’ net long positions in ZAR, BRL and MXN are high. Chart 15The RMB Is Breaking Down Chart 16Investors Are Long EM Commodity Currencies   Our recommended currency shorts for now are ZAR, PHP, IDR, COP, HUF, PEN and PLN. Global equity and credit portfolios should continue underweighting EM. Notably, global defensive equity sectors have been outperforming non-TMT stocks despite rising US/global bond yields (Chart 17). This is a major departure from the historical relationship and likely signifies a period of slower global growth ahead but continuous Fed tightening. Global equity managers should favor defensive stocks. Chart 17Does This Divergence From A Historic Correlation Signify Stagflation? For EM equity managers, we also recommend favoring defensive sectors like consumer staples. Presently, our country overweights are Korea, Singapore, Chinese A-shares, Mexico and Brazil. Our underweights are India, Central Europe, Indonesia, Turkey, South Africa, Colombia and Peru. In local rates, we continue recommending receiving Chinese and Malaysian 10-year swap rates, a long position in Brazilian 10-year bonds, betting on yield curve flattening in Mexico and paying Polish 10-year swap rates while receiving Czech 10-year swap rates. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com​​​​​​​

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary A Good Time For A Pause In The Bond Bear Market The global government bond selloff looks stretched from a technical perspective, and a consolidation phase is likely over the next few months as global growth and inflation momentum both roll over. Central banks are starting to turn more aggressive on the pace of rate hikes in the face of elevated inflation expectations, as evidenced by the 50bp rate hikes in Canada and New Zealand last week (and the likely similar move the Fed next month). However, forward pricing of policy rates over the next 12-18 months is already at or above policymaker estimates of neutral in most developed countries. Global bond yields will be capped until central banks and markets revise higher their estimates of neutral policy rates. This is more a 2023/24 story than a 2022 story. Interest rate expectations are too high in Canada. High household debt will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Bottom Line: Maintain a neutral stance on overall global duration exposure. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. How To Interpret Rising Real Bond Yields Chart 1Bonds Under Pressure From Both Inflation & Real Yields The sharp rise in global government bond yields seen so far in 2022 has been driven by both rising inflation expectations and higher real yields (Chart 1). The former is a function of the war-fueled surge in oil prices at a time of high realized inflation, while the latter is a consequence of expectations for tighter monetary policy to fight that inflation. The magnitude of the yield increases seen year-to-date is surprising given the downgrades to global growth expectations. Just this week, the IMF downgraded its growth forecasts for the second time this year. It now expects global growth to reach 3.6% in both 2022 and 2023, shaving 0.8 and 0.2 percentage points, respectively, from the last set of yearly forecasts made back in January. The World Bank similarly chopped its growth forecast for 2022 to 3.2% from 4.1%. Spillovers from the Russia/Ukraine war were the main factor behind the downgrades, including more aggressive monetary tightening by global central banks in response to commodity-fueled inflation. We’re already seeing a faster pace of rate hikes from developed market central banks. The Bank of Canada (BoC) and Reserve Bank of New Zealand (RBNZ) lifted policy rates by 50bps last week and the Fed is signaling a similar move in May. Not all policymakers are sending hawkish signals, however. The ECB last week opted to not commit to the timing and pace of any future moves on rates, while the Bank of Japan has pledged to maintain monetary stimulus measures even in the face of a collapsing yen. Related Report  Global Fixed Income StrategyPolicymakers Face The No-Win Scenario While government bond yields have risen across the developed world so far in 2022, the drivers of the yield increase have not been the same in all countries when looking at moves in benchmark 10-year nominal and inflation-linked bonds (Chart 2). About three-quarters of the nominal yield moves seen year-to-date in the US (+134bps), Canada (+136bps) and Australia (+130bps) have come from higher real yields, while the increase in the Gilt yield (+92bps) was more of an equal split between real yields and inflation breakevens. In Germany (+102bps) and Japan (+17bps), the upward move in 10-year yields this year has all been from higher breakevens, as real yields have fallen in both countries. Chart 2Real Yields (ex-Europe/Japan) Driving Nominal Yields Higher In 2022 In the US, Canada and UK – three countries where central banks have delivered rate hikes this year and are promising to do more – real yields have been highly correlated to rising interest rate expectations for the next two years taken from overnight index swap (OIS) curves (Chart 3). Meanwhile, in Germany, Japan and Australia - where central banks have kept rates steady and not sending strong messages on when that will change – the correlation between real yields and OIS-derived interest rate expectations has not been as strong (Chart 4). Chart 3Rising Real Yields Where Central Banks Have Been Hiking​​​​​ Chart 4More Stable Real Yields Where CBs Are More Dovish​​​​​ Chart 5Real Rate Expectations Have Risen Much Faster In The US The link between interest rate expectations and real yields is intuitive after factoring in inflation expectations. In Chart 5, we show actual real interest rates (policy rates minus headline CPI inflation) in the US, euro area and UK, as well as a “market-based” measure of real interest rate expectations derived as the difference between forward rates from the nominal OIS and CPI swap curves (the dotted lines). The current path for real rates is the black dotted line, while the path as of the start of 2022 is the green dotted line. In all three countries, the market-derived path for real rates over the next decade has shifted upward since the start of the year, which is consistent with a rising path for real bond yields. Yet the largest move has been in the US where real rates are expected to average around zero over the next ten years. This lines up logically with the more hawkish messaging on rates from the Fed, leading to a repricing of the 10-year TIPS yield from -1% at the start of the year to a mere -0.04% today. By contrast, real rate expectations and real yields remain negative in the euro area and UK, as both the ECB and Bank of England have been much less hawkish compared to the Fed in terms of signaling the timing and magnitude of future rate hikes. We have long flagged deeply negative real bond yields, especially in the US, as the greatest source of vulnerability for global bond markets. Such yield levels can only be sustained in a rising inflation environment if central banks deliberately keep policy rates below inflation for a long time. The Fed was not going to allow that to happen with inflation reaching levels not seen since the early 1980s, leaving US Treasuries vulnerable to a sharp repricing of fed funds rate expectations that would drive real bond yields higher. Looking ahead, we do not expect to see much additional bearish repricing of global rate expectations and real yields over the rest of 2022, for the following reasons: Global growth momentum is slowing The combined shock of geopolitical uncertainty from the Ukraine war, high oil prices and tightening global monetary policy – in addition to the expected slump in Chinese growth due to the latest wave of COVID lockdowns – has damaged economic confidence. The April reading from global ZEW survey of professional forecasters and investors showed another modest decline in US and euro area growth expectations after the huge drop in March (Chart 6). Interestingly, the ZEW survey also showed a big decline in the net number of respondents expecting higher inflation and a small dip in the number of respondents expecting higher bond yields – both potential signals that the increase in global bond yields is ready to pause. Medium-term US inflation expectations have remained relatively contained The sharp run-up in US inflation has boosted survey-based measures of inflation expectations, although the increase has been much higher for shorter-term expectations (Chart 7). One-year-ahead inflation expectations from the University of Michigan and New York Fed consumer surveys have doubled over the past year and now sit at 6.6% and 5.4%, respectively. Yet the 5-10 year ahead inflation expectation from the Michigan survey has seen a much smaller increase and is holding stable around 3%. The 5-year/5-year forward TIPS breakeven is at even less worrisome levels and now sits at a trendline resistance level of 2.4% (bottom panel). Chart 6ZEW Survey Shows Weaker Growth & Inflation Expectations​​​​​ Chart 7Medium-Term US Inflation Expectations Have Not Broken Out​​​​​ US inflation is showing early signs of peaking Year-over-year headline US CPI inflation reached another cyclical high of 8.6% in March. However, core CPI inflation rose by a less-than-expected +0.3% on the month and the year-over-year rate of 6.5% was essentially unchanged versus the February level (Chart 8). Used car prices, a huge driver of the surge in US goods inflation in 2021, fell by a sizeable -3.8% in March, the second consecutive monthly decrease. Chart 8A Peak In US Core Inflation?​​​​​ Chart 9Housing Cost Inflation Is A Global Problem We expect US consumer spending to shift more towards services from goods over the next 6-12 months, which should lead to overall US inflation rates converging more towards lower services inflation. Services inflation is still well above the Fed’s inflation target, however, particularly with shelter inflation – one-third of the overall US CPI index – now at 5.0% and showing no signs of slowing. Chart 10A Good Time For A Pause In The Bond Bear Market Rising housing costs are not only a problem in the US, and house prices and valuations have soared across the developed world (Chart 9). This suggests that housing and rental costs will remain an important driver of underlying inflation in many countries, not just the US. Summing it all up, we continue to see conditions conducive to a period of relative global bond market stability, with government bond yields remaining rangebound over the next several months. The stimulus for higher yields – from even more hawkish repricing of central bank expectations, even higher real bond yields or additional increases in inflation expectations – is not evident. Bond yields look stretched from a technical perspective, and our Global Duration Indicator continues to signal that global yield momentum should soon peak (Chart 10). Bottom Line: Maintain a neutral stance on overall global bond portfolio duration. Upgrade Canadian Government Bonds To Neutral The Bank of Canada (BoC) hiked its policy interest rate by 50bps last week to 1%, the first rate increase of that size since 2000. The BoC also announced that it will begin quantitative tightening of its balance sheet at the end of April when it stops buying Canadian government bonds to replace maturing debt it currently owns. In the press conference explaining the move, BoC Governor Tiff Macklem noted that the central bank now saw the Canadian economy in a state of “excess demand” with inflation that was “expected to be elevated for longer than we previously thought” and that “the economy could handle higher interest rates, and they are needed.” Chart 11Canadian Growth Momentum Peaking? This is a very clear hawkish message from Macklem, who hinted that the BoC may have to lift rates above neutral for a period to bring Canadian inflation back down to the central bank’s target. We have our doubts that the BoC will be able to raise rates that far, and keep them there for long, before inflation pressures ease. The BoC Business Outlook Survey plays an important role in the central bank’s policy decisions. The survey for Q1/2022 showed dips in the overall survey, and the individual components related to sales growth expectations, investment intentions and hiring plans (Chart 11). There were even small drops in the net number of survey respondents seeing intense labor shortages and expecting faster wage growth (bottom panel). The moves in these survey components were modest, but they are important coming after the relentless upward rise since the trough in mid-2020. Importantly, this survey was conducted before the Russian invasion of Ukraine, which likely provided an additional drag on business confidence. The components of the Business Outlook Survey related to prices and costs continued to show that Canadian firms are facing lingering capacity constraints and intense cost pressures from both labor and supply chain disruption. A net 80% of respondents – a survey record – report they would have some or significant difficulty meeting an unexpected increase in demand. A net 35% of respondents in the Q1/2022 survey cited “labor cost pass through” as a source of upward pressure on their output prices, a huge jump from the Q4/2022 reading of 19% (Chart 12). Also, a net 33% of respondents noted “non labor cost pass through”, i.e. higher prices due to supply chain disruption, as a source of pressure on output prices. Only a net 12% of respondents cited strong demand as a source of pressure on prices, and the net balance of respondents noting that the competitive environment was inflationary was effectively zero. Chart 12Canadian Businesses See More Cost-Push Inflation Pressures The two main messages from the Business Outlook Survey are: a) Canadian growth momentum likely cooled in Q1, and b) Canadian inflation pressures remain significant, but are more supply driven than demand driven. Overall Canadian inflation is still accelerating rapidly, with headline CPI hitting an 31-year high of 5.7% in February. Underlying measures of inflation are more subdued, but still elevated: the BoC’s CPI-trim and CPI-median measures are at 4.3% and 3.5%, respectively, both above the BoC’s 1-3% target band (Chart 13). Chart 13Mixed Messages On Canadian Inflation Expectations There are more mixed messages coming out of Canadian inflation surveys. The 1-year-ahead inflation expectation from the BoC’s Survey of Consumer Expectations climbed to 5.1% in Q1/2022 from 4.9% in Q4, while the 5-year-ahead expectation dropped to 3.2% from 3.5%. The 10-year breakeven inflation rate on Canadian inflation linked bonds is even lower, now sitting near at 2.2%. There are also very mixed signals on wage expectations, even with the Canadian unemployment rate dropping to a record low of 5.3% in March. Canadian consumers expect wage growth to reach 2.2% over the next year, below the latest reading on actual wage growth of 2.5% and far below the 5.2% growth expected by Canadian businesses (bottom panel). If medium-term consumer inflation expectations are not rising in the current high inflation environment, and consumer wage expectations are not increasing with a record-low unemployment rate, then the BoC can potentially move slower than markets expect on rate hikes over the next year if realized inflation peaks. On that front there are tentative signs of optimism. When breaking down Canadian inflation into goods and services components, both are still accelerating rapidly (Chart 14). Goods inflation reached 7.6% in February, while services inflation hit 3.8%. However, the pace of year-over-year inflation for some key durable goods components like new cars, household appliances and furniture – items that saw demand and prices increase during the worst of the pandemic – appears to have peaked (middle panel). This may be a sign that overall goods inflation is set to roll over, similarly to what we expect in the US in the coming months. Also like the US, services inflation is less likely to decelerate, as rent inflation is accelerating and the housing cost component of Canadian inflation (home replacement costs) is still expanding at a 13.2% annual rate. On that note, housing remains the key component to watch to determine the BoC’s next move, given highly levered household balance sheets exposed to house prices and higher mortgage rates. The robust strength of the Canadian housing market has driven house prices to some of the most overvalued levels among the developed economies. There is a speculative aspect to the housing boom, with Canadian households expecting house prices to appreciate by 7.1% over the next year according to the BoC consumer survey (Chart 15). Canadian housing demand has also become more sensitive to rate increases by the choice of mortgages. 30% of outstanding mortgages are now variable rate, up from 18% at the start of the pandemic in 2020 after the BoC cut rates to near-0%. Chart 14The Goods-Driven Canadian Inflation Surge May Be Peaking​​​​​​ Chart 15BoC Rate Hikes Will Cool Off Canadian Housing​​​​​​ During the BoC’s last rate hiking cycle in 2017-19, national house price inflation slowed from 15% to 0%. Policy rates had to only reach 1.75% to engineer that outcome. With household balance sheets even more levered today, and with greater exposure to variable rate mortgages, it is unlikely that a policy rate higher than the previous cycle peak will be needed to cool off house price growth – an outcome that should also dampen Canadian services inflation with its large housing related component. In addition to the rate hike at last week’s policy meeting, the BoC also announced the results of its annual revision to its estimated range for the neutral policy rate. The range is now 2-3%, up slightly from 1.75%-2.75%. The current pricing of interest rate expectations from the Canadian OIS curve has the BoC lifting rates to the high-end of that new neutral range by the first quarter of 2023, then keeping rates near those levels over at least the next five years (Chart 16). Chart 16Markets Expect The BoC To Keep Rates Elevated For Longer Chart 17Upgrade Canadian Government Bonds To Neutral We doubt the BoC will be able to raise rates all the way to 3% without inducing instability in the housing market. More importantly, the current surge in inflation is not becoming embedded in medium-term inflation and wage expectations – outcomes that would require the BoC to keep policy rates at the high end of its neutral range or even move them into restrictive territory. Turning to bond strategy, we have had Canada on “upgrade watch” in recent weeks, with rate hike expectations looking a bit too aggressive. We now see it as a good time to pull the trigger on that upgrade. Thus, this week, we are moving our recommended exposure to Canadian government bonds to neutral (3 out of 5) from underweight (Chart 17). We are “funding” that move in our model bond portfolio by reducing exposure to US Treasuries (see the tables on pages 15-16), as we see the Fed as being more likely than the BoC to deliver on the rate hike expectations discounted in OIS curves. A move to an outright overweight stance, versus all countries and not just the US, will be appropriate once Canadian inflation clearly peaks and interest rate expectations begin to decline. It is too soon to make that move now, but we will revisit that call later this year. Bottom Line: Interest rate expectations are too high in Canada with medium-term inflation expectations relatively subdued. High household debt in Canada will limit the ability for the Bank of Canada to match the Fed’s rate hikes during the current tightening cycle without bursting the Canadian housing bubble. Upgrade Canadian government bonds to neutral (3 out of 5) in global bond portfolios, ideally funded out of US Treasury allocations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary Above Fair Value March’s CPI report will mark peak inflation for 2022. We recommend several ideas to profit from peak inflation. First, investors should keep portfolio duration close to benchmark. The bond market is fairly priced for the likely near-term pace of rate hikes, and long-dated forward yields are now above fair value. Second, investors should underweight TIPS versus nominal Treasuries. They should also favor inflation curve steepeners, real yield curve flatteners and outright short positions in 2-year TIPS. Third, investors should favor the 5-year nominal Treasury note relative to a duration-matched barbell consisting of the 2-year and 10-year notes. The Fed published its plan for shrinking its balance in the minutes from the last FOMC meeting. We estimate that the Fed will be able to shrink its balance sheet at its intended pace for at least the next two years before it is forced to stop. Bottom Line: Investors should position for peak inflation by keeping portfolio duration close to benchmark, by underweighting TIPS versus nominal Treasuries and by favoring the 5-year nominal Treasury note versus the 2-year and 10-year. Feature Chart 1Base Effects Kick In Next Month Last week’s March CPI report showed that 12-month core consumer price inflation came in at 6.44%, a level that will almost certainly mark the peak for the year. Several reasons justify our peak inflation call. First, base effects will send year-over-year core CPI sharply lower during the next three months (Chart 1). Monthly core CPI growth rates were 0.86%, 0.75% and 0.80% in April, May and June 2021 (Chart 1, bottom panel). These exceptionally high prints will roll out of the 12-month average during the next three months. Second, monthly core CPI grew 0.32% in March, a significant step down from the 0.5%-0.6% range that had been the norm since October. If monthly core CPI growth rates remain between 0.3% and 0.4% from now until the end of the year, then 12-month core CPI will fall to a range of 4.19% to 5.13%. We think that trends in the major components of core inflation make this outcome likely, and we could even see inflation falling to below that range. Chart 2 shows the contributions of shelter, goods and services (ex. shelter) to overall core CPI. Chart 2Monthly Core Inflation By Major Component Starting with core goods, we see that prices fell in March for the first time since February 2021. This represents an important inflection point. Core goods, particularly autos, have been the principal driver of current extremely high inflation rates (Chart 3), and these prices will continue to fall in the coming months as supply chain issues are resolved and as goods spending reverts to its pre-pandemic trend (Chart 3, bottom panel). Few dispute that core goods inflation will be weaker going forward. However, one critical question is whether the impact from falling goods prices will simply be offset by the rising cost of services. There was indeed some evidence for this in March. Core services (ex. shelter) prices rose 0.71% in March, up from 0.55% in February. While this is a strong print, it was not sufficient to prevent a drop in overall core inflation from 0.51% to 0.32%. What’s more, March’s core services print was heavily influenced by a surge in airfares that represents a rebound from steep declines seen near the end of last year. With airfares excluded, core services inflation would have only come in at 0.50% in March (Chart 4). Chart 3Goods Inflation Chart 4Services & Shelter Inflation Finally, we turn to the outlook for shelter inflation. Monthly shelter inflation has rebounded to above its pre-COVID levels, but its acceleration has abated during the past few months (Chart 4, bottom panel). Trends in home prices and some indicators of market rents suggest that shelter inflation has some further near-term upside.1 However, shelter inflation is also very sensitive to the economic cycle and the unemployment rate. With that in mind, rapid shelter inflation during the past 12 months is mostly explained by the fact that the unemployment rate fell by almost 2.5%! With the labor market already close to full employment, this sort of cyclical economic improvement will not be repeated during the next 12 months. All in all, we think monthly shelter inflation will average close to its current level during the next nine months. Bottom Line: March’s CPI report marked an inflection point for inflation. Year-over-year inflation will fall sharply during the next few months and will settle close to 4% by the end of the year. Profiting From Peak Inflation Portfolio Duration We have been recommending an “at benchmark” portfolio duration stance in US bond portfolios since mid-February, yet Treasury yields have continued their upward march during the past two months. Our sense is that bond yields now look somewhat too high, and some pullback is likely as inflation moves lower during the next few months. First, let’s consider that the bond market is priced for 262 bps of tightening during the next 12 months (Chart 5), the equivalent of more than ten 25 basis point rate hikes at the next eight FOMC meetings. Our view is that this pricing is close to fair. Chart 5Rate Expectations A 50 basis point rate hike at the May FOMC meeting is now a near certainty. The minutes from the last meeting revealed that “many” participants would have preferred a 50 bps increase in March, but uncertainty surrounding the war in Ukraine prevented that view from becoming consensus. The Treasury curve has also re-steepened significantly during the past few weeks, a development that will ease any concerns about near-term over-tightening. It’s also worth noting that the precedent for a 50 bps hike has now been set by the Reserve Bank of New Zealand and the Bank of Canada. Both central banks lifted their policy rates by 50 bps at their most recent meetings. Chart 6Above Fair Value Beyond May, we expect to see more 25 basis point rate hikes than 50 basis point hikes. Falling inflation will ease some of the Fed’s urgency and the Fed will continue to tighten policy with the goal of getting the fed funds rate close to estimates of the long-run neutral rate by the end of the year. A 25 basis point rate increase at every meeting after May would bring the fed funds rate to a range of 2.0% - 2.25% by the end of the year, just below the Fed’s median estimate of the long-run neutral rate (2.4%). One additional 50 bps hike would bring the funds rate right up to neutral, and such a path would still be consistent with what is currently priced in the curve. Meanwhile, bond pricing at the long end of the yield curve now looks a touch cheap. The 5-year/5-year forward Treasury yield – a market proxy for the long-run neutral rate – has moved up to 2.87%, significantly above survey estimates of the long-run neutral rate (Chart 6). Some pullback closer to survey levels is likely as inflation trends lower. Bottom Line: Keep portfolio duration close to benchmark. Front-end pricing looks fair and long-dated forward yields are somewhat too high. TIPS Perhaps the most obvious way to profit from peak inflation in 2022 is by shorting TIPS versus nominal Treasuries. The 10-year TIPS breakeven inflation rate has risen to 2.91%, well above the Fed’s target range of 2.3%-2.5% (Chart 7). The combination of Fed tightening and falling inflation will send this rate back toward the Fed’s target between now and the end of the year. However, the potential downside in the 10-year TIPS breakeven inflation rate is nothing compared to the 2-year rate. The 2-year TIPS breakeven inflation rate is 4.4% (Chart 7, panel 2) and this short-maturity rate is much more sensitive to the incoming inflation data. Finally, long-maturity TIPS breakeven inflation rates look elevated compared to survey estimates of long run inflation. The 5-year/5-year forward TIPS breakeven inflation rate is currently 2.46%, above the range of estimates from the New York Fed’s Survey of Primary Dealers (Chart 7, bottom panel). In addition to underweight positions in TIPS versus nominal Treasuries, we continue to see the opportunity for an outright short position in 2-year TIPS. The 2-year TIPS yield has risen significantly since the end of last year, but this has been driven by a rising 2-year nominal yield (Chart 8). Going forward, the 2-year TIPS yield still has room to rise but it’s increase will be driven less by a rising nominal yield and more by a falling 2-year TIPS breakeven inflation rate. Chart 7Inflation Expectations Chart 8Sell 2-Year TIPS Consistent with our view that the cost of short-maturity inflation compensation has more downside than the cost of long-maturity inflation compensation, we view positions in 2-year/10-year inflation curve steepeners and 2-year/10-year TIPS curve flatteners as likely to profit during the next nine months (Chart 8, bottom panel). Bottom Line: Investors should underweight TIPS versus nominal Treasuries. They should also position in inflation curve steepeners and real yield curve flatteners and hold outright short positions in 2-year TIPS. Nominal Treasury Curve Chart 9Go Long 5yr Versus 2/10 One final idea is for investors to take a long position in the 5-year Treasury note versus a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. This 5 over 2/10 trade currently offers an attractive 18 bps of yield pick-up, which is much higher than we normally see when the 2-year/10-year Treasury slope is this flat (Chart 9). In fact, a simple model of the 2/5/10 butterfly spread versus the 2-year/10-year slope shows the 5-year bullet to be very cheap relative to history (Chart 9, panel 2). This position will profit from continued 2-year/10-year curve steepening, or more likely, it will profit if the 2-year/10-year slope remains near its current level but the 2-year/5-year slope flattens as the Fed tightening cycle progresses (Chart 9, panel 3). Bottom Line: The recent steepening trend in the 2-year/10-year Treasury slope is likely exhausted, but the 5-year Treasury yield is too high relative to the current 2-year/10-year slope. Investors should go long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The Fed’s Balance Sheet Plan The minutes from the March FOMC meeting revealed the Fed’s plan for shrinking its balance sheet. This plan will likely be put into action at either the May or June FOMC meeting. Specifically, the Fed intends to allow a maximum of $60 billion of Treasuries and $35 billion of MBS to passively run off its portfolio each month. The Fed also hinted that it may decide to start with lower caps and raise them up to the $60 billion and $35 billion targets over a period of three months. However, with the market already well positioned for Quantitative Tightening (QT), this phase-in period will probably not be deemed necessary. For its Treasury securities, the Fed intends to allow a maximum of $60 billion of coupon securities to run off its portfolio each month. If fewer than $60 billion of coupon securities are maturing that month, then the Fed will redeem T-bills to reach the $60 billion target. For MBS, the Fed’s $35 billion per month cap will probably not be binding. Given the slow pace of mortgage refinancings, which will only slow further as interest rates rise, it is unlikely that there will be many months with more than $35 billion of maturing MBS. In fact, some recent Fed research estimated that average MBS runoff will be closer to $25 billion per month going forward.2 Assuming the Fed’s plan starts in June and that MBS runoff averages $25 billion per month, we calculate that the Fed’s Treasury holdings and total assets will still be above pre-COVID levels in 2026 (Chart 10). More important than the Fed’s total assets, however, are the total reserves supplied to the banking system. It is the amount of reserves, after all, that determine whether the Fed can maintain adequate control over interest rates. If too few reserves are supplied, then the fed funds rate will threaten to break above the upper end of the Fed’s target band and the Fed will be forced to increase reserves by either re-starting purchases or engaging in repo transactions. This is exactly what happened when the Fed was forced to abandon its last QT effort in September 2019 (Chart 11). Chart 10Fed Asset Projections Chart 11Reserve Projections Making a few additional assumptions about the growth rate of currency-in-circulation and the size of the Treasury’s General Account, we are able to forecast the path for reserves going forward (Chart 11, top panel). We estimate that reserves will fall to roughly $2 trillion by the end of 2025, still slightly above the levels that caused problems in fall 2019. Ultimately, neither us nor the Fed knows exactly what level of reserves will be adequate to maintain control of interest rates going forward. The Fed will track usage of its new Standing Repo Facility as it shrinks its balance sheet. If usage of the repo facility increases, that will be the sign that the Fed has done enough QT and it is time to start slowly increasing the balance sheet once again. Given the recently published pace of runoff, we think this won’t be story for at least another two years.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 https://www.newyorkfed.org/newsevents/speeches/2022/log220302 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns